IRS Tax Attorney: Economic substance doctrine

http://www.irs.gov/Businesses/Codification-of-Economic-Substance-Doctrine-and-Related-Penalties

Section 1409 of the Health Care and Education Reconciliation Act of 2010 (Act), Pub. L. No. 111-152, added section 7701(o) to codify the economic substance doctrine and amended penalty provisions under sections 6662, 6662A, 6664, and 6676.

Under section 7701(o), a transaction is treated as having economic substance only if it passes a conjunctive, two prong test. The test requires that (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position and; (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

The Health Care and Education Affordability Reconciliation Act of 2010 (the “Act”), signed by President Obama on March 30, 2010, includes

The Act adds new Section 7701(o) to the Code, which could adversely affect how investors and businesses make and dispose of their investment. In general, new section 7701(o) provides that a taxpayer whose facts otherwise satisfy the technical legal requirements for a tax benefit shall be denied that tax benefit if (a) the taxpayer was motivated to arrange the transaction by a purpose to obtain that tax benefit, (b) the benefit was not among the purposes Congress had contemplated in enacting the pertinent statute, and (c) the taxpayer fails to prove satisfaction of the economic substance test once the IRS asserts its application. A transaction that is properly challenged by the IRS will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from U.S. federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from U.S. federal income tax effects) for entering into such transaction.

The judicial “economic substance” doctrine has existed for many years, and new section 7701(o) is not intended to depart radically from that judicial doctrine. The most important feature of section 7701(o) is its penalty regime. In general, if a taxpayer is found to have violated section 7701(o), a 20% penalty is imposed on the amount of underpaid tax. The penalty is increased to 40% if the transaction is not adequately disclosed on the taxpayer’s timely-filed tax return. There is no exception for reasonable reliance on a tax opinion or other reasonable cause or good faith, as was the case under prior law.

In the past, the economic substance doctrine has been applied most frequently in perceived “tax shelter” cases. On occasion, in the late 1990s and early 2000s, a few investors and companies engaged in such transactions in making and disposing of their investments. The IRS successfully challenged many of these “tax shelter” transactions. With the new penalty regime, the stakes are higher for taxpayers.

The Joint Committee on Taxation (JCT) explanation indicates that the new provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice, are respected, even though they are largely tax motivated. Specific examples provided include (1) the choice between capitalizing a business enterprise with debt or equity, (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment, and (3) the choice to enter a transaction or series of transactions that constitute a tax-free corporate reorganization.

The JCT explanation further provides that if the realization of tax benefits of a transaction is consistent with the Congressional purpose, it is not intended that such tax benefits be subject to penalties under section 7701(o). Obvious examples of this would likely include selling an investment at a loss to harvest a tax benefit or investing in a tax-free municipal bond. The only examples provided in the JCT explanation as intended not to be subject to section 7701(o) are where a tax credit—such as the section 42 low-income housing credit, the section 45 production tax credit, the section 45D new markets tax credit, the section 47 rehabilitation tax credit, the section 48 energy tax credit—are used 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. A subsequent Nixon Peabody alert will address in greater detail how new section 7701(o) impacts tax credit transactions.

Previously, in analyzing an IRS audit of a particular transaction based on the “economic substance” doctrine, some courts considered the investor’s potential ability to profit from the investment. New section 7701(o) now requires that when the investor’s ability to profit is considered, the pre-tax profit must be substantial in relation to the present value of the expected net tax benefits. This standard appears to be much more difficult to meet than under most case law.

The Act adds new Section 7701(o) to the Code, which could adversely affect how investors

and businesses make and dispose of their investment. In general, new section 7701(o)

provides that a taxpayer whose facts otherwise satisfy the technical legal requirements for a

tax benefit shall be denied that tax benefit if (a) the taxpayer was motivated to arrange the

transaction by a purpose to obtain that tax benefit, (b) the benefit was not among the

purposes Congress had contemplated in enacting the pertinent statute, and (c) the taxpayer

fails to prove satisfaction of the economic substance test once the IRS asserts its application.

A transaction that is properly challenged by the IRS will be treated as having economic

substance only if (1) the transaction changes in a meaningful way (apart from U.S. federal

income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial

purpose (apart from U.S. federal income tax effects) for entering into such transaction.

The judicial “economic substance” doctrine has existed for many years and new section

7701(o) is not intended to depart radically from that judicial doctrine. The most important

feature of section 7701(o) is its penalty regime. In general, if a taxpayer is found to have

violated section 7701(o), a 20% penalty is imposed on the amount of underpaid tax. The

penalty is increased to 40% if the transaction is not adequately disclosed on the taxpayer’s

timely-filed tax return. There is no exception for reasonable reliance on a tax opinion or other

reasonable cause or good faith, as was the case under prior law.

In the past, the economic substance doctrine has been applied most frequently in perceived

“tax shelter” cases. On occasion, in the late 1990s and early 2000s, a few investors and

companies engaged in such transactions in making and disposing of their investments. The

IRS successfully challenged many of these “tax shelter” transactions. With the new penalty

regime, the stakes are higher for taxpayers.

Internal Revenue Bulletin: 2010-40

October 4, 2010

Notice 2010-62

Interim Guidance Under the Codification of the Economic Substance Doctrine and Related Provisions in the Health Care and Education Reconciliation Act of 2010

Table of Contents

PURPOSE

This notice provides interim guidance regarding the codification of the economic substance doctrine under section 7701(o) and the related amendments to the penalties under sections 6662, 6662A, 6664, and 6676 by section 1409 of the Health Care and Education Reconciliation Act of 2010 (Act), Pub. L. No. 111-152. The notice applies with respect to transactions entered into on or after March 31, 2010, which is the effective date for the amendments made by section 1409 of the Act.

BACKGROUND

Section 1409 of the Act added new section 7701(o) to the Code. Section 7701(o)(1) provides that, in the case of any transaction to which the economic substance doctrine is relevant, the transaction shall be treated as having economic substance only if (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. Section 7701(o)(5)(A) states that the term “economic substance doctrine” means 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.

Section 7701(o)(5)(C) states that the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if section 7701(o) had never been enacted. With respect to individuals, however, section 7701(o)(5)(B) states that the two-prong analysis in section 7701(o)(1) shall apply only to a transaction entered into in connection with a trade or business or an activity engaged in for the production of income. In addition, section 7701(o)(5)(D) states that the term “transaction” as used in section 7701(o) includes a series of transactions.

Section 7701(o)(2)(A) provides that a transaction’s potential for profit shall be taken into account in determining whether the requirements of section 7701(o)(1) are met only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the claimed net tax benefits. For purposes of computing pre-tax profit, section 7701(o)(2)(B) provides that the Secretary shall issue regulations treating foreign taxes as a pre-tax expense in appropriate cases.

The Act also added section 6662(b)(6), which provides that the accuracy-related penalty imposed under section 6662(a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet any similar rule of law (collectively a section 6662(b)(6) transaction). The Act also added section 6662(i), which increases the accuracy-related penalty from 20 to 40 percent for any portion of an underpayment attributable to one or more section 6662(b)(6) transactions with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return. Furthermore, new section 6662(i)(3) provides that certain amended returns or any supplement to a return shall not be taken into consideration for purposes of section 6662(i).

The Act amended section 6664(c) so that the reasonable cause exception for underpayments found in section 6664(c)(1) shall not apply to any portion of any underpayment attributable to a section 6662(b)(6) transaction. The Act similarly amended section 6664(d) so that the reasonable cause exception found in section 6664(d)(1) shall not apply to any reportable transaction understatement (within the meaning of section 6662A(b)) attributable to a section 6662(b)(6) transaction. The Act also amended section 6676 so that any excessive amount (within the meaning of section 6676(b)) attributable to any section 6662(b)(6) transaction shall not be treated as having a reasonable basis.

APPLICATION OF THE ECONOMIC SUBSTANCE DOCTRINE WITH RESPECT TO TRANSACTIONS ENTERED INTO AFTER THE EFFECTIVE DATE OF THE ACT

A. Application of the Conjunctive Test

For transactions entered into on or after March 31, 2010, to which the economic substance doctrine is relevant, section 7701(o)(1) mandates the use of a conjunctive two-prong test to determine whether a transaction shall be treated as having economic substance. The first prong, found in section 7701(o)(1)(A), requires that the transaction change in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position. The second prong, found in section 7701(o)(1)(B), requires that the taxpayer have a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

The IRS will continue to rely on relevant case law under the common-law economic substance doctrine in applying the two-prong conjunctive test in section 7701(o)(1). Accordingly, in determining whether a transaction sufficiently affects the taxpayer’s economic position to satisfy the requirements of section 7701(o)(1)(A), the IRS will apply cases under the common-law economic substance doctrine (as identified in section 7701(o)(5)(A)) pertaining to whether the tax benefits of a transaction are not allowable because the transaction does not satisfy the economic substance prong of the economic substance doctrine. Similarly, in determining whether a transaction has a sufficient nontax purpose to satisfy the requirements of section 7701(o)(1)(B), the IRS will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose.

The IRS will challenge taxpayers who seek to rely on prior case law under the common-law economic substance doctrine for the proposition that a transaction will be treated as having economic substance merely because it satisfies either section 7701(o)(1)(A) (or its common-law corollary) or section 7701(o)(1)(B) (or its common-law corollary). For all transactions subject to section 1409 of the Act that otherwise would have been subject to a common-law economic substance analysis that treated a transaction as having economic substance merely because it satisfies either section 7701(o)(1)(A) (or its common-law corollary) or section 7701(o)(1)(B) (or its common-law corollary) the IRS will apply a two-prong conjunctive test consistent with section 7701(o).

B. Determination of Economic Substance Transactions

Section 7701(o)(5)(C) provides that the determination of whether a transaction is subject to the economic substance doctrine shall be made in the same manner as if section 7701(o) had never been enacted. In addition, section 7701(o)(1) only applies in the case of any transaction to which the economic substance doctrine is relevant. Consistent with these provisions, the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of section 7701(o). If authorities, prior to the enactment of section 7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. The IRS anticipates that the case law regarding the circumstances in which the economic substance doctrine is relevant will continue to develop. Consistent with section 7701(o)(5)(C), codification of the economic substance doctrine should not affect the ongoing development of authorities on this issue. The Treasury Department and the IRS do not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply.

C. Calculating Net Present Value of the Reasonably Expected Pre-tax Profit.

In determining whether the requirements of section 7701(o)(1)(A) and (B) are met, the IRS will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for Federal income tax purposes. In performing this calculation, the IRS will apply existing relevant case law and other published guidance.

D. Treatment of Foreign Taxes as Expenses in Appropriate Cases.

Section 7701(o)(2)(B) provides that the Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. The Treasury Department and the IRS intend to issue regulations pursuant to section 7701(o)(2)(B). In the interim, the enactment of the provision does not restrict the ability of the courts to consider the appropriate treatment of foreign taxes in economic substance cases.

ACCURACY-RELATED PENALTIES

Unless the transaction is a reportable transaction, as defined in Treas. Reg. § 1.6011-4(b), the adequate disclosure requirements of section 6662(i) will be satisfied if a taxpayer adequately discloses on a timely filed original return (determined with regard to extensions) or a qualified amended return (as defined under Treas. Reg. § 1.6664-2(c)(3)) the relevant facts affecting the tax treatment of the transaction. If a disclosure would be considered adequate for purposes of section 6662(d)(2)(B) (without regard to section 6662(d)(2)(C)) prior to the enactment of section 1409 of the Act, then it will be deemed to be adequate for purposes of section 6662(i). The disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS consistent with the instructions and other guidance associated with those subsequent forms, publications, or other guidance. Disclosures made consistent with the terms of Rev. Proc. 94-69 also will be taken into account for purposes of section 6662(i). If a transaction lacking economic substance is a reportable transaction, as defined in Treas. Reg. § 1.6011-4(b), the adequate disclosure requirement under section 6662(i)(2) will be satisfied only if the taxpayer meets the disclosure requirements described earlier in this paragraph and the disclosure requirements under the section 6011 regulations. Similarly, a taxpayer will not meet the disclosure requirements for a reportable transaction under the section 6011 regulations by only attaching Form 8275 or 8275-R to an original or qualified amended return.

EFFECT ON OTHER DOCUMENTS

The IRS will not issue a private letter ruling or determination letter pursuant to section 3.02 (1) of Rev. Proc. 2010-3, 2010-1 I.R.B. 110 (or subsequent guidance), regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o). Accordingly, Rev. Proc. 2010-3 is modified.

REQUEST FOR COMMENTS

The IRS is interested in comments concerning the disclosure requirements set forth in this notice with regard to section 6662(i), especially with regard to the interplay between Rev. Proc. 94-69, proposed Schedule UTP, and the LMSB compliance assurance process (CAP) program. Interested parties are invited to submit comments on this notice by December 3, 2010. Comments should be submitted to: Internal Revenue Service, CC:PA:LPD:PR (Notice 2010-62), Room 5205, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224. Alternatively, comments may be hand-delivered Monday through Friday between the hours of 8:00 a.m. to 4:00 p.m. to: CC:PA:LPD:PR (Notice 2010-62), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC. Comments may also be submitted electronically via the following e-mail address: Notice.Comments@irscounsel.treas.gov. Please include Notice 2010-62 in the subject line of any electronic submissions.

EFFECTIVE DATE

This notice is effective with respect to transactions entered into on or after March 31, 2010.

CONTACT INFORMATION

The principal author of this notice is James G. Hartford of the Office of Associate Chief Counsel (Procedure and Administration). For further information regarding this notice, contact James G. Hartford at (202) 622-7950 (not a toll-free call). For further information with respect to the treatment of foreign taxes as expenses, contact Suzanne M. Walsh at (202) 622-3850 (not a toll-free call).

COMREP Codification of economic substance doctrine and penalties. [P.L. 111-152]

(Health Care and Education Reconciliation Act, , PL 111-152, 3/30/2010)

Joint Committee on Taxation Report

Present Law

In general

The Code provides detailed rules specifying the computation of taxable income, including the amount, timing, source, and character of items of income, gain, loss, and deduction. These rules permit both taxpayers and the government to compute taxable income with reasonable accuracy and predictability. Taxpayers generally may plan their transactions in reliance on these rules to determine the Federal income tax consequences arising from the transactions.

In addition to the statutory provisions, courts have developed several doctrines that can be applied to deny the tax benefits of a tax-motivated transaction, notwithstanding that the transaction may satisfy the literal requirements of a specific tax provision. These common-law doctrines are not entirely distinguishable, and their application to a given set of facts is often blurred by the courts, the IRS, and litigants. Although these doctrines serve an important role in the administration of the tax system, they can be seen as at odds with an objective, “rule-based” system of taxation.

One common-law doctrine applied over the years is the “economic substance” doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in Federal income tax. 300

See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Texas 2007), aff'd 568 F.3d 537 (5th Cir. 2009); Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), vacating and remanding 62 Fed. Cl. 716 (2004) (slip opinion at 123-124, 128); cert. denied, 127 S. Ct. 1261 (Mem.) (2007).

Closely related doctrines also applied by the courts (sometimes interchangeable with the economic substance doctrine) include the “sham transaction doctrine” and the “business purpose doctrine.” See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest deductions on a “sham transaction” that lacked “commercial economic substance”). Certain “substance over form” cases involving tax-indifferent parties, in which courts have found that the substance of the transaction did not comport with the form asserted by the taxpayer, have also involved examination of whether the change in economic position that occurred, if any, was consistent with the form asserted, and whether the claimed business purpose supported the particular tax benefits that were claimed. See, e.g., TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006); BB&T Corporation v. United States, 2007-1 USTC P 50,130 (M.D.N.C. 2007), aff'd 523 F.3d 461 (4th Cir. 2008). Although the Second Circuit found for the government in TIFD III-E, Inc., on remand to consider issues under section 704(e), the District Court found for the taxpayer. See, TIFD III-E Inc. v. United States, No. 3:01-cv-01839, 2009 WL 3208650 (D. Conn. Oct. 23, 2009).

Economic substance doctrine

Courts generally deny claimed tax benefits if the transaction that gives rise to those benefits lacks economic substance independent of U.S. Federal income tax considerations notwithstanding that the purported activity actually occurred. The Tax Court has described the doctrine as follows:

The tax law . . . requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction. The doctrine of economic substance becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, by means of transactions that serve no economic purpose other than tax savings. 301

301 ACM Partnership v. Commissioner, 73 T.C.M. at 2215.

Business purpose doctrine

A common law doctrine that often is considered together with the economic substance doctrine is the business purpose doctrine. The business purpose doctrine involves an inquiry into the subjective motives of the taxpayer — that is, whether the taxpayer intended the transaction to serve some useful non-tax purpose. In making this determination, some courts have bifurcated a transaction in which activities with non-tax objectives have been combined with unrelated activities having only tax-avoidance objectives, in order to disallow the tax benefits of the overall transaction. 302

See, ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

Application by the courts

Elements of the doctrine

There is a lack of uniformity regarding the proper application of the economic substance doctrine. 303 Some courts apply a conjunctive test that requires a taxpayer to establish the presence of both economic substance (i.e., the objective component) and business purpose (i.e., the subjective component) in order for the transaction to survive judicial scrutiny. 304 A narrower approach used by some courts is to conclude that either a business purpose or economic substance is sufficient to respect the transaction. 305 A third approach regards economic substance and business purpose as “simply more precise factors to consider” in determining whether a transaction has any practical economic effects other than the creation of tax benefits.

“The casebooks are glutted with [economic substance] tests. Many such tests proliferate because they give the comforting illusion of consistency and precision. They often obscure rather than clarify.” Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988).

See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (“The threshold question is whether the transaction has economic substance. If the answer is yes, the question becomes whether the taxpayer was motivated by profit to participate in the transaction.”). See also, Klamath Strategic Investment Fund v. United States, 568 F. 3d 537, (5th Cir. 2009) (even if taxpayers may have had a profit motive, a transaction was disregarded where it did not in fact have any realistic possibility of profit and funding was never at risk).

See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985) (“To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and, second, that the transaction has no economic substance because no reasonable possibility of a profit exists.”); IES Industries v. United States , 253 F.3d 350, 358 (8th Cir. 2001) (“In determining whether a transaction is a sham for tax purposes [under the Eighth Circuit test], a transaction will be characterized as a sham if it is not motivated by any economic purpose outside of tax considerations (the business purpose test), and if it is without economic substance because no real potential for profit exists (the economic substance test).”). As noted earlier, the economic substance doctrine and the sham transaction doctrine are similar and sometimes are applied interchangeably. For a more detailed discussion of the sham transaction doctrine, see, e.g., Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (including Provisions Relating to Corporate Tax Shelters) (JCS-3-99) at 182.

See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 1995); Sacks v. Commissioner, 69 F.3d 982, 985 (9th Cir. 1995) (“Instead, the consideration of business purpose and economic substance are simply more precise factors to consider . . . We have repeatedly and carefully noted that this formulation cannot be used as a 'rigid two-step analysis'.”)

One decision by the Court of Federal Claims questioned the continuing viability of the doctrine. That court also stated that “the use of the 'economic substance' doctrine to trump 'mere compliance with the Code' would violate the separation of powers” though that court also found that the particular transaction at issue in the case did not lack economic substance. The Court of Appeals for the Federal Circuit (“Federal Circuit Court”) overruled the Court of Federal Claims decision, reiterating the viability of the economic substance doctrine and concluding that the transaction in question violated that doctrine. 307 The Federal Circuit Court stated that “[w]hile the doctrine may well also apply if the taxpayer's sole subjective motivation is tax avoidance even if the transaction has economic substance, [footnote omitted], a lack of economic substance is sufficient to disqualify the transaction without proof that the taxpayer's sole motive is tax avoidance.”

Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716 (2004) (slip opinion at 123-124, 128); vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (Mem.) (2007).

The Federal Circuit Court stated that “when the taxpayer claims a deduction, it is the taxpayer who bears the burden of proving that the transaction has economic substance.” The Federal Circuit Court quoted a decision of its predecessor court, stating that “Gregory v. Helvering requires that a taxpayer carry an unusually heavy burden when he attempts to demonstrate that Congress intended to give favorable tax treatment to the kind of transaction that would never occur absent the motive of tax avoidance.” The Court also stated that “while the taxpayer's subjective motivation may be pertinent to the existence of a tax avoidance purpose, all courts have looked to the objective reality of a transaction in assessing its economic substance.” Coltec Industries, Inc. v. United States, 454 F.3d at 1355, 1356.

Nontax economic benefits

There also is a lack of uniformity regarding the type of non-tax economic benefit a taxpayer must establish in order to demonstrate that a transaction has economic substance. Some courts have denied tax benefits on the grounds that a stated business benefit of a particular structure was not in fact obtained by that structure. 309 Several courts have denied tax benefits on the grounds that the subject transactions lacked profit potential. 310 In addition, some courts have applied the economic substance doctrine to disallow tax benefits in transactions in which a taxpayer was exposed to risk and the transaction had a profit potential, but the court concluded that the economic risks and profit potential were insignificant when compared to the tax benefits. 311 Under this analysis, the taxpayer's profit potential must be more than nominal. Conversely, other courts view the application of the economic substance doctrine as requiring an objective determination of whether a “reasonable possibility of profit” from the transaction existed apart from the tax benefits. 312 In these cases, in assessing whether a reasonable possibility of profit exists, it may be sufficient if there is a nominal amount of pre-tax profit as measured against expected tax benefits.

See, e.g., Coltec Industries v. United States, 454 F.3d 1340 (Fed. Cir. 2006). The court analyzed the transfer to a subsidiary of a note purporting to provide high stock basis in exchange for a purported assumption of liabilities, and held these transactions unnecessary to accomplish any business purpose of using a subsidiary to manage asbestos liabilities. The court also held that the purported business purpose of adding a barrier to veil-piercing claims by third parties was not accomplished by the transaction. 454 F.3d at 1358-1360 (Fed. Cir. 2006).

See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying prepaid interest deduction, lacked economic substance).

See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 (disallowing deduction even though taxpayer had a possibility of small gain or loss by owning Treasury bills); Sheldon v. Commissioner, 94 T.C. 738, 768 (1990) (stating that “potential for gain . . . is infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions”).

See, e.g., Rice's Toyota World v. Commissioner, 752 F. 2d 89, 94 (4th Cir. 1985) (the economic substance inquiry requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781 (5th Cir. 2001) (applied the same test, citing Rice's Toyota World); IES Industries v. United States, 253 F.3d 350, 354 (8th Cir. 2001); Wells Fargo & Company v. United States, No. 06-628T, 2010 WL 94544, at *57-58 (Fed. Cl. Jan. 8, 2010).

Financial accounting benefits

In determining whether a taxpayer had a valid business purpose for entering into a transaction, at least two courts have concluded that financial accounting benefits arising from tax savings do not qualify as a non-tax business purpose. 313 However, based on court decisions that recognize the importance of financial accounting treatment, taxpayers have asserted that financial accounting benefits arising from tax savings can satisfy the business purpose test.

See American Electric Power, Inc. v. United States , 136 F. Supp. 2d 762, 791-92 (S.D. Ohio 2001), aff'd, 326 F.3d.737 (6th Cir. 2003) and Wells Fargo & Company v. United States, No. 06-628T, 2010 WL 94544, at *59 (Fed. Cl. Jan. 8, 2010).

See, e.g., Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JSC-3-03) February, 2003 (“Enron Report”), Volume III at C-93, 289. Enron Corporation relied on Frank Lyon Co. v. United States, 435 U.S. 561, 577-78 (1978), and Newman v. Commissioner, 902 F.2d 159, 163 (2d Cir. 1990), to argue that financial accounting benefits arising from tax savings constitute a good business purpose.

Tax-indifferent parties

A number of cases have involved transactions structured to allocate income for Federal tax purposes to a tax-indifferent party, with a corresponding deduction, or favorable basis result, to a taxable person. The income allocated to the tax-indifferent party for tax purposes was structured to exceed any actual economic income to be received by the tax indifferent party from the transaction. Courts have sometimes concluded that this particular type of transaction did not satisfy the economic substance doctrine. 315 In other cases, courts have indicated that the substance of a transaction did not support the form of income allocations asserted by the taxpayer and have questioned whether asserted business purpose or other standards were met.

See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).

See, e.g., TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006). Although the Second Circuit found for the government in TIFD III-E, Inc., on remand to consider issues under section 704(e), the District Court found for the taxpayer. See, TIFD III-E Inc. v. United States, No. 3:01-cv-01839, 2009 WL 3208650 (Oct. 23, 2009).

Penalty regime

General accuracy-related penalty

An accuracy-related penalty under section 6662 applies to the portion of any underpayment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement. If the correct income tax liability exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 (or, in the case of corporations, by the lesser of (a) 10 percent of the correct tax (or $10,000 if greater) or (b) $10 million), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. 317 The section 6662 penalty is increased to 40 percent in the case of gross valuation misstatements as defined in section 6662(h). Except in the case of tax shelters, 318 the amount of any understatement is reduced by any portion attributable to an item if (1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment. The Treasury Secretary may prescribe a list of positions which the Secretary believes do not meet the requirements for substantial authority under this provision.

Sec. 6662.

A tax shelter is defined for this purpose as a partnership or other entity, an investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, other entity, plan, or arrangement is the avoidance or evasion of Federal income tax. Sec. 6662(d)(2)(C).

The section 6662 penalty generally is abated (even with respect to tax shelters) in cases in which the taxpayer can demonstrate that there was “reasonable cause” for the underpayment and that the taxpayer acted in good faith. 319 The relevant regulations for a tax shelter provide that reasonable cause exists where the taxpayer “reasonably relies in good faith on an opinion based on a professional tax advisor's analysis of the pertinent facts and authorities [that] . . . unambiguously concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged” by the IRS. 320 For transactions other than tax shelters, the relevant regulations provide a facts and circumstances test, the most important factor generally being the extent of the taxpayer's effort to assess the proper tax liability. If a taxpayer relies on an opinion, reliance is not reasonable if the taxpayer knows or should have known that the advisor lacked knowledge in the relevant aspects of Federal tax law, or if the taxpayer fails to disclose a fact that it knows or should have known is relevant. Certain additional requirements apply with respect to the advice. 321

Sec. 6664(c).

Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c) .

See Treas. Reg. Sec. 1.6664-4(c). In addition to the requirements applicable to taxpayers under the regulations, advisors may be subject to potential penalties under section 6694 (applicable to return preparers), and to monetary penalties and other sanctions under Circular 230 (which provides rules governing persons practicing before the IRS). Under Circular 230, if a transaction is a “covered transaction” (a term that includes listed transactions and certain non-listed reportable transactions) a “more likely than not” confidence level is required for written tax advice that may be relied upon by a taxpayer for the purpose of avoiding penalties, and certain other standards must also be met. Treasury Dept. Circular 230 (Rev. 4-2008) Sec. 10.35. For other tax advice, Circular 230 generally requires a lower “realistic possibility” confidence level or a “non-frivolous” confidence level coupled with advising the client of any opportunity to avoid the accuracy related penalty under section 6662 by adequate disclosure. Treasury Dept. Circular 230 (Rev. 4-2008) Sec. 10.34.

Listed transactions and reportable avoidance transactions

In general

A separate accuracy-related penalty under section 6662A applies to any “listed transaction” and to any other “reportable transaction” that is not a listed transaction, if a significant purpose of such transaction is the avoidance or evasion of Federal income tax 322 (hereinafter referred to as a “reportable avoidance transaction”). The penalty rate and defenses available to avoid the penalty vary depending on whether the transaction was adequately disclosed.

Sec. 6662A(b)(2).

Both listed transactions and other reportable transactions are allowed to be described by the Treasury department under section 6011 as transactions that must be reported, and section 6707A(c) imposes a penalty for failure adequately to report such transactions under section 6011. A reportable transaction is defined as one that the Treasury Secretary determines is required to be disclosed because it is determined to have a potential for tax avoidance or evasion. 323 A listed transaction is defined as a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of the reporting disclosure requirements. 324

Sec. 6707A(c)(1).

Sec. 6707A(c)(2).

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement attributable to an adequately disclosed listed transaction or reportable avoidance transaction. 325 The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause and good faith exception (hereinafter referred to as the “strengthened reasonable cause exception”), which is described below. The strengthened reasonable cause exception is available only if the relevant facts affecting the tax treatment were adequately disclosed, there is or was substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the claimed tax treatment was more likely than not the proper treatment. A “reasonable belief” must be based on the facts and law as they exist at the time that the return in question is filed, and not take into account the possibility that a return would not be audited. Moreover, reliance on professional advice may support a “reasonable belief” only in certain circumstances. 326

325

Sec. 6662A(a).

326

Section 6664(d)(3)(B) does not allow a reasonable belief to be based on a “disqualified opinion” or on an opinion from a “disqualified tax advisor.”

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable cause exception is not available (i.e., a strict liability penalty generally applies), and the taxpayer is subject to an increased penalty equal to 30 percent of the understatement. 327 However, a taxpayer will be treated as having adequately disclosed a transaction for this purpose if the IRS Commissioner has separately rescinded the separate penalty under section 6707A for failure to disclose a reportable transaction. 328 The IRS Commissioner is authorized to do this only if the failure does not relate to a listed transaction and only if rescinding the penalty would promote compliance and effective tax administration. 329

327

Sec. 6662A(c).

328

Sec. 6664(d).

329

Sec. 6707A(d).

A public entity that is required to pay a penalty for an undisclosed listed or reportable transaction must disclose the imposition of the penalty in reports to the SEC for such periods as the Secretary specifies. The disclosure to the SEC applies without regard to whether the taxpayer determines the amount of the penalty to be material to the reports in which the penalty must appear, and any failure to disclose such penalty in the reports is treated as a failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the SEC once the taxpayer has exhausted its administrative and judicial remedies with respect to the penalty (or if earlier, when paid). 330

330

Sec. 6707A(e).

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or reportable avoidance transaction without regard to other items on the tax return. For purposes of this provision, the amount of the understatement is determined as the sum of: (1) the product of the highest corporate or individual tax rate (as appropriate) and the increase in taxable income resulting from the difference between the taxpayer's treatment of the item and the proper treatment of the item (without regard to other items on the tax return); 331 and (2) the amount of any decrease in the aggregate amount of credits which results from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item.

331

For this purpose, any reduction in the excess of deductions allowed for the taxable year over gross income for such year, and any reduction in the amount of capital losses which would (without regard to section 1211) be allowed for such year, will be treated as an increase in taxable income. Sec. 6662A(b).

Except as provided in regulations, a taxpayer's treatment of an item will not take into account any amendment or supplement to a return if the amendment or supplement is filed after the earlier of when the taxpayer is first contacted regarding an examination of the return or such other date as specified by the Secretary. 332

332

Sec. 6662A(e)(3).

Strengthened reasonable cause exception

A penalty is not imposed under section 6662A with respect to any portion of an understatement if it is shown that there was reasonable cause for such portion and the taxpayer acted in good faith. Such a showing requires: (1) adequate disclosure of the facts affecting the transaction in accordance with the regulations under section 6011; 333 (2) that there is or was substantial authority for such treatment; and (3) that the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be treated as having a reasonable belief with respect to the tax treatment of an item only if such belief: (1) is based on the facts and law that exist at the time the tax return (that includes the item) is filed; and (2) relates solely to the taxpayer's chances of success on the merits and does not take into account the possibility that (a) a return will not be audited, (b) the treatment will not be raised on audit, or (c) the treatment will be resolved through settlement if raised. 334

333

See the previous discussion regarding the penalty for failing to disclose a reportable transaction.

334

Sec. 6664(d).

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not rely on an opinion of a tax advisor for this purpose if the opinion (1) is provided by a “disqualified tax advisor” or (2) is a “disqualified opinion.”

Disqualified tax advisor

A disqualified tax advisor is any advisor who: (1) is a material advisor 335 and who participates in the organization, management, promotion, or sale of the transaction or is related (within the meaning of section 267(b) or 707(b)(1)) to any person who so participates; (2) is compensated directly or indirectly 336 by a material advisor with respect to the transaction; (3) has a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sustained; or (4) as determined under regulations prescribed by the Secretary, has a disqualifying financial interest with respect to the transaction.

335

The term “material advisor” means any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, or carrying out any reportable transaction, and who derives gross income in excess of $50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons ($250,000 in any other case). Sec. 6111(b)(1).

336

This situation could arise, for example, when an advisor has an arrangement or understanding (oral or written) with an organizer, manager, or promoter of a reportable transaction that such party will recommend or refer potential participants to the advisor for an opinion regarding the tax treatment of the transaction.

A material advisor is considered as participating in the “organization” of a transaction if the advisor performs acts relating to the development of the transaction. This may include, for example, preparing documents: (1) establishing a structure used in connection with the transaction (such as a partnership agreement); (2) describing the transaction (such as an offering memorandum or other statement describing the transaction); or (3) relating to the registration of the transaction with any Federal, state, or local government body. 337 Participation in the “management” of a transaction means involvement in the decision-making process regarding any business activity with respect to the transaction. Participation in the “promotion or sale” of a transaction means involvement in the marketing or solicitation of the transaction to others. Thus, an advisor who provides information about the transaction to a potential participant is involved in the promotion or sale of a transaction, as is any advisor who recommends the transaction to a potential participant.

337

An advisor should not be treated as participating in the organization of a transaction if the advisor's only involvement with respect to the organization of the transaction is the rendering of an opinion regarding the tax consequences of such transaction. However, such an advisor may be a “disqualified tax advisor” with respect to the transaction if the advisor participates in the management, promotion, or sale of the transaction (or if the advisor is compensated by a material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or as determined by the Secretary, has a continuing financial interest with respect to the transaction). See , 2005-1 C.B. 494 regarding disqualified compensation arrangements.

Disqualified opinion

An opinion may not be relied upon if the opinion: (1) is based on unreasonable factual or legal assumptions (including assumptions as to future events); (2) unreasonably relies upon representations, statements, finding or agreements of the taxpayer or any other person; (3) does not identify and consider all relevant facts; or (4) fails to meet any other requirement prescribed by the Secretary.

Coordination with other penalties

Any understatement upon which a penalty is imposed under section 6662A is not subject to the accuracy related penalty for underpayments under section 6662. 338 However, that understatement is included for purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a substantial understatement under section 6662(d)(1). 339 Thus, in the case of an understatement (as defined in sec. 6662(d)(2)), the amount of the understatement (determined without regard to section 6662A(e)(1)(A)) is increased by the aggregate amount of reportable transaction understatements for purposes of determining whether the understatement is a substantial understatement. The section 6662(a) penalty applies only to the excess of the amount of the substantial understatement (if any) after section 6662A(e)(1)(A) is applied over the aggregate amount of reportable transaction understatements. 340 Accordingly, every understatement is penalized, but only under one penalty provision.

338

Sec. 6662(b) (flush language). In addition, section 6662(b) provides that section 6662 does not apply to any portion of an underpayment on which a fraud penalty is imposed under section 6663.

339

Sec. 6662A(e)(1).

340

Sec. 6662(d)(2)(A) (flush language)

The penalty imposed under section 6662A does not apply to any portion of an understatement to which a fraud penalty applies under section 6663 or to which the 40-percent penalty for gross valuation misstatements under section 6662(h) applies. 341

341

Sec. 6662A(e)(2).

Erroneous claim for refund or credit

If a claim for refund or credit with respect to income tax (other than a claim relating to the earned income tax credit) is made for an excessive amount, unless it is shown that the claim for such excessive amount has a reasonable basis, the person making such claim is subject to a penalty in an amount equal to 20 percent of the excessive amount. 342

342

Sec. 6676.

The term “excessive amount” means the amount by which the amount of the claim for refund for any taxable year exceeds the amount of such claim allowable for the taxable year.

This penalty does not apply to any portion of the excessive amount of a claim for refund or credit which is subject to a penalty imposed under the accuracy related or fraud penalty provisions (including the general accuracy related penalty, or the penalty with respect to listed and reportable transactions, described above).

Explanation of Provision

The provision clarifies and enhances the application of the economic substance doctrine. Under the provision, new section 7701(o) provides that in the case of any transaction 343 to which the economic substance doctrine is relevant, such transaction is treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (2) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. The provision provides a uniform definition of economic substance, but does not alter the flexibility of the courts in other respects.

343

The term “transaction” includes a series of transactions.

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. Thus, the provision does not change present law standards in determining when to utilize an economic substance analysis. 344

344

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 tax benefits be disallowed. See, e.g., Treas. Reg. sec. 1.269-2, stating that characteristic of circumstances in which an amount otherwise constituting a deduction, credit, or other allowance is not available are those in which the effect of the deduction, credit, or other allowance would be to distort the liability of the particular taxpayer when the essential nature of the transaction or situation is examined in the light of the basic purpose or plan which the deduction, credit, or other allowance was designed by the Congress to effectuate. Thus, for example, it is not intended that a tax credit (e.g., section 42 (low-income housing credit), section 45 (production tax credit), section 45D (new markets tax credit), section 47 (rehabilitation credit), section 48 (energy credit), 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.

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. Among 345 these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; 346 (2) a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; 347 (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; 348 and (4) 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. 349 Leasing transactions, like all other types of transactions, will continue to be analyzed in light of all the facts and circumstances. 350 As under present law, whether a particular transaction meets the requirements for specific treatment under any of these provisions is a question of facts and circumstances. Also, the fact that a transaction meets the requirements for specific treatment under any provision of the Code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance. 351

345

The examples are illustrative and not exclusive.

346

See, e.g., John Kelley Co. v. Commissioner , 326 U.S. 521 (1946) (respecting debt characterization in one case and not in the other, based on all the facts and circumstances).

347

See, e.g., Sam Siegel v. Commissioner, 45. T.C. 566 (1966), acq. 1966-2 C.B. 3. But see Commissioner v. Bollinger, 485 U.S. 340 (1988) (agency principles applied to title-holding corporation under the facts and circumstances).

348

See, e.g., 2010-1 I.R.B. 110, Secs. 3.01(38), (39),(40,) and (42) (IRS will not rule on certain matters relating to incorporations or reorganizations unless there is a “significant issue”); compare Gregory v. Helvering, 293 U.S. 465 (1935).

349

See, e.g., National Carbide v. Commissioner, 336 U.S. 422 (1949), Moline Properties v. Commissioner, 319 U.S. 435 (1943); compare, e.g. Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971), acq., 1972-2 C.B. 1; Commissioner v. Bollinger, 485 U.S. 340 (1988); see also sec. 7701(l).

350

See, e.g., Frank Lyon Co. v. Commissioner, 435 U.S. 561 (1978); Hilton v. Commissioner, 74 T.C. 305, aff'd, 671 F. 2d 316 (9th Cir. 1982), cert. denied, 459 U.S. 907 (1982); Coltec Industries v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (Mem) (2007); BB&T Corporation v. United States, 2007-1 USTC P 50,130 (M.D.N.C. 2007), aff'd, 523 F.3d 461 (4th Cir. 2008); Wells Fargo & Company v. United States, No. 06-628T, 2010 WL 94544, at *60 (Fed. Cl. Jan. 8, 2010) (distinguishing leasing case Consolidated Edison Company of New York, No. 06-305T, 2009 WL 3418533 (Fed. Cl. Oct. 21, 2009) by observing that “considerations of economic substance are factually specific to the transaction involved”).

351

As examples of cases in which courts have found that a transaction does not meet the requirements for the treatment claimed by the taxpayer under the Code, or does not have economic substance, see e.g., BB&T Corporation v. United States, 2007-1 USTC P 50,130 (M.D.N.C. 2007) aff'd, 523 F.3d 461 (4th Cir. 2008); Tribune Company and Subsidiaries v. Commissioner, 125 T.C. 110 (2005); H.J. Heinz Company and Subsidiaries v. United States, 76 Fed. Cl. 570 (2007); Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied 127 S. Ct. 1261 (Mem.) (2007); Long Term Capital Holdings LP v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff'd, 150 Fed. Appx. 40 (2d Cir. 2005); Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Texas 2007); aff'd, 568 F. 3d 537 (5th Cir. 2009); Santa Monica Pictures LLC v. Commissioner, 89 T.C.M. 1157 (2005).

The provision does not alter the court's ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine. For example, the provision reiterates the present-law ability of the courts 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. 352

352

See, e.g., Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied 127 S. Ct. 1261 (Mem.) (2007) (“the first asserted business purpose focuses on the wrong transaction--the creation of Garrison as a separate subsidiary to manage asbestos liabilities. . . . [W]e must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale...”) 454 F.3d 1340, 1358 (Fed. Cir. 2006). See also ACM Partnership v. Commissioner, 157 F.3d at 256 n.48; Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) (“A given result at the end of a straight path is not made a different result because reached by following a devious path.”).

Conjunctive analysis

The provision clarifies that the economic substance doctrine involves a conjunctive analysis — there must be an inquiry regarding the objective effects of the transaction on the taxpayer's economic position as well as an inquiry regarding the taxpayer's subjective motives for engaging in the transaction. Under the provision, a transaction must satisfy both tests, i.e., the transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position and the taxpayer must have a substantial non-Federal-income-tax purpose for entering into such transaction, in order for a transaction to be treated as having economic substance. This clarification eliminates the disparity that exists among the Federal circuit courts regarding the application of the doctrine, and modifies its application in those circuits in which either a change in economic position or a non-tax business purpose (without having both) is sufficient to satisfy the economic substance doctrine. 353

353

The provision defines “economic substance doctrine” 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. Thus, the definition includes any doctrine that denies tax benefits for lack of economic substance, for lack of business purpose, or for lack of both.

Non-Federal-income-tax business purpose

Under the provision, a taxpayer's non-Federal-income-tax purpose 354 for entering into a transaction (the second prong in the analysis) must be “substantial.” For purposes of this analysis, any State or local income tax effect which is related to a Federal income tax effect is treated in the same manner as a Federal income tax effect. Also, a purpose of achieving a favorable accounting treatment for financial reporting purposes is not taken into account as a non-Federal-income-tax purpose if the origin of the financial accounting benefit is a reduction of Federal income tax. 355

354

See, e.g., Treas. Reg. sec. 1.269-2(b) (stating that a distortion of tax liability indicating the principal purpose of tax evasion or avoidance might be evidenced by the fact that “the transaction was not undertaken for reasons germane to the conduct of the business of the taxpayer”). Similarly, in ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189 (1997), the court stated:

Key to [the determination of whether a transaction has economic substance] is that the transaction must be rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. Both the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs. [citations omitted]

355

Claiming that a financial accounting benefit constitutes a substantial non-tax purpose fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and significantly diminishes the purpose for having a substantial non-tax purpose requirement. See, e.g., American Electric Power, Inc. v. United States, 136 F. Supp. 2d 762, 791-92 (S.D. Ohio 2001) (“AEP's intended use of the cash flows generated by the [corporate-owned life insurance] plan is irrelevant to the subjective prong of the economic substance analysis. If a legitimate business purpose for the use of the tax savings 'were sufficient to breathe substance into a transaction whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed,'”) (citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)); aff'd, 326 F3d 737 (6th Cir. 2003).

Profit potential

Under the provision, 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 for entering into such transaction. The provision does not require or establish a minimum return that will satisfy the profit potential test. However, if a taxpayer relies on a profit potential, the present value of the reasonably expected pre-tax profit must be substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. 356 Fees and other transaction expenses are taken into account as expenses in determining pre-tax profit. In addition, the Secretary is to issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. 357

356

See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d at 94 (the economic substance inquiry requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. Commissioner, 277 F.3d at 781 (applied the same test, citing Rice's Toyota World); IES Industries v. United States, 253 F.3d at 354 (the application of the objective economic substance test involves determining whether there was a “reasonable possibility of profit . . . apart from tax benefits.”). 357

There is no intention to restrict the ability of the courts to consider the appropriate treatment of foreign taxes in particular cases, as under present law.

Personal transactions of individuals

In the case of an individual, the provision applies only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.

Other rules

No inference is intended as to the proper application of the economic substance doctrine under present law. The provision is not intended to alter or supplant any other rule of law, including any common-law doctrine or provision of the Code or regulations or other guidance thereunder; and it is intended the provision be construed as being additive to any such other rule of law.

As with other provisions in the Code, the Secretary has general authority to prescribe rules and regulations necessary for the enforcement of the provision. 358

358

Sec. 7805(a).

Penalty for underpayments and understatements attributable to transactions lacking economic substance

The provision imposes a new strict liability penalty under section 6662 for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance, as defined in new section 7701(o), or failing to meet the requirements of any similar rule of law. 359 The penalty rate is 20 percent (increased to 40 percent if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return). An amended return or supplement to a return is not taken into account if filed after the taxpayer has been contacted for audit or such other date as is specified by the Secretary. No exceptions (including the reasonable cause rules) to the penalty are available. Thus, under the provision, outside opinions or in-house analysis would not protect a taxpayer from imposition of a penalty if it is determined that the transaction lacks economic substance or fails to meet the requirements of any similar rule of law. Similarly, a claim for refund or credit that is excessive under section 6676 due to a claim that is lacking in economic substance or failing to meet the requirements of any similar rule of law is subject to the 20 percent penalty under that section, and the reasonable basis exception is not available.

359

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 does not apply to any portion of an underpayment on which a fraud penalty is imposed. 360 The new 40-percent penalty for nondisclosed transactions is added to the penalties to which section 6662A will not also apply. 361

360

As under present law, the penalties under section 6662 (including the new penalty) do not apply to any portion of an underpayment on which a fraud penalty is imposed.

361

As revised by the provision, new section 6662A(e)(2)(b) provides that section 6662A will not apply to any portion of an understatement due to gross valuation misstatement under section 6662(h) or nondisclosed noneconomic substance transactions under new section 6662(i).

As described above, under the provision, the reasonable cause and good faith exception of present law section 6664(c)(1) does not apply to any portion of an underpayment which is attributable to a transaction lacking economic substance, as defined in section 7701(o), or failing to meet the requirements of any similar rule of law. Likewise, the reasonable cause and good faith exception of present law section 6664(d)(1) does not apply to any portion of a reportable transaction understatement which is attributable to a transaction lacking economic substance, as defined in section 7701(o), or failing to meet the requirements of any similar rule of law.

Effective Date

The provision applies to transactions entered into after the date of enactment and to underpayments, understatements, and refunds and credits attributable to transactions entered into after the date of enactment.

Rev. Rul. 99-14, 1999-1 CB 835, 3/12/1999, IRC Sec(s). 162COMREP ¶ 77,011.0009 Codification of economic substance doctrine and penalties. [P.L. 111-152] (Health Care and Education Reconciliation Act, , PL 111-152, 3/30/2010)

Joint Committee on Taxation Report

Present Law

In general

300

Economic substance doctrine

301

ACM Partnership v. Commissioner, 73 T.C.M. at 2215.

Business purpose doctrine

302

See, ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

Application by the courts

Elements of the doctrine

303

304

305

306

307

Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716 (2004) (slip opinion at 123-124, 128); vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (Mem.) (2007).

308

Nontax economic benefits

309

310

311

312

Financial accounting benefits

313

314

Tax-indifferent parties

315

See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).

316

Penalty regime

General accuracy-related penalty

317

Sec. 6662.

318

319

Sec. 6664(c).

320

Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c) .

321

Listed transactions and reportable avoidance transactions

In general

322

Sec. 6662A(b)(2).

323

Sec. 6707A(c)(1).

324

Sec. 6707A(c)(2).

Disclosed transactions

325

Sec. 6662A(a).

326

Section 6664(d)(3)(B) does not allow a reasonable belief to be based on a “disqualified opinion” or on an opinion from a “disqualified tax advisor.”

Undisclosed transactions

327

Sec. 6662A(c).

328

Sec. 6664(d).

329

Sec. 6707A(d).

330

Sec. 6707A(e).

Determination of the understatement amount

331

332

Sec. 6662A(e)(3).

Strengthened reasonable cause exception

333

See the previous discussion regarding the penalty for failing to disclose a reportable transaction.

334

Sec. 6664(d).

Disqualified tax advisor

335

336

337

Disqualified opinion

Coordination with other penalties

338

Sec. 6662(b) (flush language). In addition, section 6662(b) provides that section 6662 does not apply to any portion of an underpayment on which a fraud penalty is imposed under section 6663.

339

Sec. 6662A(e)(1).

340

Sec. 6662(d)(2)(A) (flush language)

341

Sec. 6662A(e)(2).

Erroneous claim for refund or credit

342

Sec. 6676.

The term “excessive amount” means the amount by which the amount of the claim for refund for any taxable year exceeds the amount of such claim allowable for the taxable year.

Explanation of Provision

343

The term “transaction” includes a series of transactions.

344

345

The examples are illustrative and not exclusive.

346

See, e.g., John Kelley Co. v. Commissioner , 326 U.S. 521 (1946) (respecting debt characterization in one case and not in the other, based on all the facts and circumstances).

347

348

349

350

351

352

Conjunctive analysis

353

Non-Federal-income-tax business purpose

354

355

Profit potential

356

357

There is no intention to restrict the ability of the courts to consider the appropriate treatment of foreign taxes in particular cases, as under present law.

Personal transactions of individuals

In the case of an individual, the provision applies only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.

Other rules

As with other provisions in the Code, the Secretary has general authority to prescribe rules and regulations necessary for the enforcement of the provision. 358

358

Sec. 7805(a).

Penalty for underpayments and understatements attributable to transactions lacking economic substance

359

360

As under present law, the penalties under section 6662 (including the new penalty) do not apply to any portion of an underpayment on which a fraud penalty is imposed.

361

Effective Date

Trade or business expenses—rentals.

Headnote:

“Lease-in/lease-out” transaction between U.S. corp. and foreign municipality was disregarded for lack of economic substance, and no deductions were allowed for either rent or interest. Obligations of both parties are offset, and risk exposure is almost completely eliminated in “headlease” and “sublease” transaction, which provided circular cash flow.

Reference(s): ¶ 1625.291; Code Sec. 162;

Full Text:

Issue

May a taxpayer deduct, under sections 162 and 163 of the Internal Revenue Code, rent and interest paid or incurred in connection with a “lease-in/lease-out” (“LILO”) transaction?

Facts

X is a U.S. corporation. FM is a foreign municipality that has historically owned and used certain property having a remaining useful life of 50 years and a fair market value of $100 million. BK1 and BK2 are banks. None of the parties is related.

The Headlease requires X to make two rental payments to FM during its 34-year term:

(1) an $89 million “prepayment” at the beginning of year 1; and

(2) a “postpayment” at the end of year 34 that has a discounted present value of $8 million.

For federal income tax purposes, X and FM allocate the prepayment ratably to the first 6 years of the Headlease and the future value of the postpayment ratably to the remaining 28 years of the Headlease.

The Sublease requires FM to make fixed, annual rental payments over both the primary term and, if exercised, the put renewal term. The fixed, annual payments during the put renewal term are substantially higher than those for the primary term. Nevertheless, the fixed, annual payments during the put renewal term are projected (as of January 1, 1997) to equal only 90 percent of the fair market value rental amounts for that term.

At the end of the Sublease primary term, FM has a “fixed- payment option” to purchase from X the Headlease residual (the right to use the property beyond the Sublease primary term subject to the obligation to make the rent postpayment) for a fixed amount that is projected (as of January 1, 1997) to be equal to the fair market value of the Headlease residual. If FM exercises the option, the transaction is terminated at that point and X is not required to make any portion of the postpayment due under the Headlease. If FM does not exercise the option, X may elect to:

(1) use the property itself for the remaining term of the Headlease,

(2) lease the property to another person for the remaining term of the Headlease, or

(3) compel FM to lease the property for the 10-year put renewal term of the Sublease.

If FM does not exercise the fixed-payment option and X exercises its put renewal option, X can require FM to purchase a letter of credit guaranteeing the put renewal rents. If FM does not obtain the letter of credit, FM must exercise the fixed-payment option.

To partially fund the $89 million Headlease prepayment, X borrows $54 million from BK1 and $6 million from BK2. Both loans are nonrecourse, have fixed interest rates, and provide for annual debt service payments that fully amortize the loans over the 20-year primary term of the Sublease. The amount and timing of the debt service payments mirror the amount and timing of the Sublease payments due during the primary term of the Sublease.

Upon receiving the $89 million Headlease prepayment, FM deposits $54 million into a deposit account with an affiliate of BK1 and $6 million into a deposit account with an affiliate of BK2. The deposits with the affiliates of BK1 and BK2 earn interest at the same rates as the loans from BK1 and BK2. FM directs the affiliate of BK1 to pay BK1 annual amounts equal to 90 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK1). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK1 as debt service payments. In addition, FM pledges the deposit account to X as security for FM's obligations under the Sublease, while X, in turn, pledges its interest in FM's pledge to BK1 as security for X's obligations under the loan from BK1. Similarly, FM directs the affiliate of BK2 to pay BK2 annual amounts equal to 10 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK2). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK2 as debt service payments. Although this deposit account is not pledged, the parties understand that FM will use the account to pay the remaining 10 percent of FM's annual rent obligation under the Sublease.

X requires FM to invest $15 million of the Headlease prepayment in highly-rated debt securities that will mature in an amount sufficient to fund the fixed amount due under the fixed- payment option, and to pledge these debt securities to X. Having economically defeased both its rental obligations under the Sublease and its fixed payment under the fixed-payment option, FM keeps the remaining portion of the Headlease prepayment as its return on the transaction.

For tax purposes, X claims deductions for interest on the loans and for the allocated rents on the Headlease. X includes in gross income the rents received on the Sublease and, if and when exercised, the payment received on the fixed payment option. By accounting for each element of the transaction separately, X purports to generate a stream of substantial net deductions in the early years of the transaction followed by net income inclusions on or after the conclusion of the Sublease primary term. As a result, X anticipates a substantial net after-tax return from the transaction. X also anticipates a positive pre-tax economic return from the transaction. However, this pre-tax return is insignificant in relation to the net after-tax return.

Law and Analysis

In general, a transaction will be respected for tax purposes if it has “economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax- independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached.” Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 [41 AFTR 2d 78-1142] (1978); James v. Commissioner, 899 F.2d 905, 908-09 [65 AFTR 2d 90-1045] (10th Cir. 1990). In assessing the economic substance of a transaction, a key factor is whether the transaction has any practical economic effect other than the creation of tax losses. Courts have refused to recognize the tax consequences of a transaction that does not appreciably affect the taxpayer's beneficial interest except to reduce tax. The presence of an insignificant pre-tax profit is not enough to provide a transaction with sufficient economic substance to be respected for tax purposes. Knetsch v. United States, 364 U.S. 361, 366 [6 AFTR 2d 5851] (1960); ACM Partnership v. Commissioner, 157 F.3d 231, 248 [82 AFTR 2d 98-6682] (3d Cir. 1998); Sheldon v. Commissioner, 94 T.C. 738, 768 (1990).

In determining whether a transaction has sufficient economic substance to be respected for tax purposes, courts have recognized that offsetting legal obligations, or circular cash flows, may effectively eliminate any real economic significance of the transaction. For example, in Knetsch, the taxpayer purchased an annuity bond using nonrecourse financing. However, the taxpayer repeatedly borrowed against increases in the cash value of the bond. Thus, the bond and the taxpayer's borrowings constituted offsetting obligations. As a result, the taxpayer could never derive any significant benefit from the bond. The Supreme Court found the transaction to be a sham, as it produced no significant economic effect and had been structured only to provide the taxpayer with interest deductions.

In Sheldon, the Tax Court denied the taxpayer the purported tax benefits of a series of Treasury bill sale-repurchase transactions because they lacked economic substance. In the transactions, the taxpayer bought Treasury bills that matured shortly after the end of the tax year and funded the purchase by borrowing against the Treasury bills. The taxpayer accrued the majority of its interest deduction on the borrowings in the first year while deferring the inclusion of its economically offsetting interest income from the Treasury bills until the second year. The transactions lacked economic substance because the economic consequences of holding the Treasury bills were largely offset by the economic cost of the borrowings. The taxpayer was denied the tax benefit of the transactions because the real economic impact of the transactions was “infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions.” Sheldon at 769.

In ACM Partnership, the taxpayer entered into a near- simultaneous purchase and sale of debt instruments. Taken together, the purchase and sale “had only nominal, incidental effects on [the taxpayer's] net economic position.” ACM Partnership at 250. The taxpayer claimed that, despite the minimal net economic effect, the transaction had a large tax effect resulting from the application of the installment sale rules to the sale. The court held that transactions that do not “appreciably” affect a taxpayer's beneficial interest, except to reduce tax, are devoid of substance and are not respected for tax purposes. ACM Partnership at 248. The court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits.

Viewed as a whole, the objective facts of the LILO transaction indicate that the transaction lacks the potential for any significant economic consequences other than the creation of tax benefits. During the 20-year primary term of the Sublease, X's obligation to make the property available under the Sublease is completely offset by X's right to use the property under the Headlease. X's obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by X's right to receive Sublease rentals from FM. Moreover, X's exposure to the risk that FM will not make the rent payments is further limited by the arrangements with the affiliates of BK1 and BK2. In the case of the loan from BK1, X's economic risk is completely eliminated through the defeasance arrangement. In the case of the smaller loan from BK2, X's economic risk, although not completely eliminated, is substantially reduced through the deposit arrangement. As a result, neither bank requires an independent source of funds to make the loans, or bears significant risk of nonpayment. In short, during the Sublease primary term, the offsetting and circular nature of the obligations eliminate any significant economic consequences of the transaction.

At the end of the 20-year Sublease primary term, X will have either the proceeds of the fixed-payment option or a Headlease residual that has a fair market value approximately equal to the proceeds of the fixed payment option. If, at the end of the 20-year Sublease primary term, the Headlease residual is worth more than the payment required on the fixed-payment option, FM will capture this excess value by exercising the fixed payment option, leaving X with only the proceeds of the option. Conversely, if, at the end of the 20-year Sublease primary term, the Headlease residual is worth significantly less than the payment required on the fixed-payment option, X will put the property back to FM under the put renewal option at rents, that while initially projected to be at only 90 percent of estimated fair market value, are (because of the decline in the value of the property) greater than fair market value. Thus, the fixed payment option and put renewal option operate to “collar” the value of the Headlease residual during the primary term, limiting much of the economic consequence of the Headlease residual.

In addition, facts indicate that there is little economic consequence from X's nominal exposure to FM's credit under the fixed- payment option and, if exercised, the put renewal term. At the inception of the transaction, FM was required to use a portion of the Headlease prepayment to purchase highly-rated debt securities that were pledged to X, ensuring FM's ability to make the payment under the fixed-payment option. If FM does not exercise the fixed-payment option and X exercises the put renewal option, X can require FM to purchase a letter of credit guaranteeing FM's obligation to make the put renewal rent payments. If FM does not obtain the letter of credit, FM must exercise the fixed-payment option. Thus, as a practical matter, the transaction is structured so that X is never subject to FM's credit.

The conclusion that X is insulated from any significant economic consequence of the Headlease residual is further supported by several factors indicating that the parties expect FM to exercise the fixed-payment option. First, FM has historically used the property. Second, because the fixed payment obligation is fully defeased, FM need not draw on other sources of capital to exercise the option. However, if FM does not exercise the fixed payment option and X exercises the put renewal option, FM would be required to draw on other sources of capital to satisfy its put renewal rental obligations.

In sum, the LILO transaction lacks the potential for significant economic consequences other than the creation of tax benefits. During the primary term of the Sublease, X's obligations to provide property are completely offset by its right to use property. X's obligations to make debt service payments on the loans are completely offset by X's right to receive rent on the Sublease. These cash flows are further assured by the deposit arrangements with the affiliates of BK1 and BK2. Finally, X's economic exposure to the Headlease residual is rendered insignificant by the option structure and the pledge of the securities that defeases FM's option payment. Thus, the only real economic consequence of the LILO transaction during the 20-year primary term of the Sublease is X's pre-tax return. This pre-tax return is too insignificant, when compared to X's after-tax yield, to support a finding that the transaction has significant economic consequences other than the creation of tax benefits.

Some of the features of the LILO transaction discussed above are present in transactions that the Service will respect for federal income tax purposes. For example, an arrangement for “in- substance defeasance” of an outstanding debt was respected in Rev. Rul. 85-42, 1985-1 C.B. 36. By contrast, in the LILO transaction, the deposit arrangement exists from the inception of the transaction, eliminating any need by BK1 and BK2 for an independent source of funds. Similarly, other features of the LILO transaction, such as nonrecourse financing and fixed-payment options, are respected in other contexts. However, when these and other features are viewed as a whole in the context of the LILO transaction, these features indicate the transaction should not be respected for tax purposes.

As a result of the transaction lacking economic substance, X may not deduct interest or rent paid or incurred in connection with the transaction.

The Service will scrutinize LILO transactions for lack of economic substance and/or, in appropriate cases, recharacterize transactions for federal income tax purposes based on their substance. See, e.g., Gregory v. Helvering 293 U.S. 465 [14 AFTR 1191] (1935), Bussing v. Commissioner, 88 T.C. 449 (1987), Supplemental Opinion, 89 T.C. 1050 (1987). Use of terms such as “loan,” “lease,” “Headlease,” and “Sublease” in this revenue ruling should not be interpreted to indicate the Service's acceptance of X's characterization of the LILO transaction described above.

Holding

A taxpayer may not deduct, under sections 162 and 163, rent and interest paid or incurred in connection with a LILO transaction that lacks economic substance.

Effect on Other Documents

Rev. Rul. 85-42 is distinguished.

Drafting Information

The principal author of this revenue ruling is John Aramburu of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling contact Mr. Aramburu on (202) 622-4960 (not a toll-free call).

ev. Rul. 2002-69, 2002-2 CB 760, 10/11/2002, IRC Sec(s). 162

Trade or business expenses—rentals.

Headnote:

As announced in IR 2002-108, IRS has affirmed earlier guidance that taxpayer cannot deduct under either Code Sec. 162; or Code Sec. 163; rent and interest paid or incurred in lease-in/lease-out (LILO) transaction that is properly characterized as conferring only future interest in property. Rev Rul 99-14, 1999-1 CB 835, is modified and superseded.

Reference(s): ¶ 1625.291; Code Sec. 162;

Full Text:

Issue

May a taxpayer deduct currently, under §§ 162 and 163 of the Internal Revenue Code, rent and interest paid or incurred in connection with a Alease-in/lease-out@ (ALILO@) transaction?

Facts

X is a U.S. corporation. FM is a foreign municipality that has historically owned and used certain property. As of 1997, it is estimated that the property has a remaining useful life of 50 years and a fair market value of $100 million. BK1 and BK2 are banks. None of these four parties is related to any of the others.

On January 1, 1997, X and FM entered into a LILO transaction under which FM leased the property to X under a “Headlease,” and X immediately leased the property back to FM under a “Sublease.” The term of the Headlease is 40 years. The primary term of the Sublease is 20 years. Moreover, as described below, the Sublease also may be renewed for a term of 10 years (Aput renewal term@) at the option of X. X's right to possess the property under the Headlease for the first 20 years is substantially the same as FM's right to possession under the Sublease for the primary term. The Headlease requires X to make two rental payments to FM during its 40-year term: (1) an $89 million prepayment at the beginning of year 1; and (2) a postpayment at the end of year 40 that has a discounted present value of $8 million. For federal income tax purposes, X and FM allocate the prepayment ratably to the first 6 years of the Headlease and the future value of the postpayment ratably to the remaining 34 years of the Headlease.

The Sublease requires FM to make fixed, annual rental payments over both the primary term and, if exercised, the put renewal term. The fixed, annual payments during the put renewal term are equal to 90 percent of the amounts that (as of January 1, 1997) are projected to be the fair market value rental amounts for that term.

Upon receiving the $89 million Headlease prepayment, FM deposits $54 million into a deposit account with an affiliate of BK1 and $6 million into a deposit account with an affiliate of BK2. The deposits with the affiliates of BK1 and BK2 earn interest at the same rates as the loans from BK1 and BK2. FM directs the affiliate of BK1 to pay BK1 annual amounts equal to 90 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK1). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK1 as debt service payments. In addition, FM pledges the deposit account to X as security for FM 's obligations under the Sublease, while X, in turn, pledges its interest in FM's pledge to BK1 as security for X's obligations under the loan from BK1. Similarly, FM directs the affiliate of BK2 to pay BK2 annual amounts equal to 10 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK2). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK2 as debt service payments. Although FM's deposit with the BK2 affiliate is not pledged, the parties understand that FM will use the account to pay the remaining 10 percent of FM's annual rent obligation under the Sublease.

As a result of the foregoing arrangement, X's obligation to make the property available under the 20-year primary term of the Sublease is completely offset by X's right to use the property under the Headlease. X's obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by X's right to receive Sublease rentals from FM. Moreover, X's exposure to the risk that FM will not make the rent payments is further limited by the arrangements with the affiliates of BK1 and BK2. In the case of the loan from BK1, X 's economic risk is eliminated through the defeasance arrangement. In the case of the $6 million loan from BK2, X 's economic risk, although not eliminated, is substantially reduced through the deposit arrangement. As a result, neither bank requires an independent source of funds to make the loans, or bears significant risk of nonpayment. In short, during the primary Sublease term, the transaction is characterized by reciprocal and circular obligations that offset one another.

At the end of the Sublease primary term, FM has a fixed-payment option to purchase from X the Headlease residual (the right to use the property beyond the Sublease primary term subject to the obligation to make the rent postpayment) for a fixed exercise price equal to 105 percent of the amount that (as of January 1, 1997) is projected to be the future fair market value of the Headlease residual. If FM exercises the option, the transaction is terminated at that point, and X receives the exercise price of the option and is not required to make any portion of the postpayment due under the Headlease. If FM does not exercise the option, X may elect to (1) use the property itself for the remaining term of the Headlease, (2) lease the property to another person for the remaining term of the Headlease, or (3) compel FM to lease the property for the 10-year put renewal term of the Sublease. If FM does not exercise the fixed-payment option and X exercises its put renewal option, X will receive rents that are equal to 90 percent of the amounts that are (as of January 1, 1997) projected to be the fair market rents for that term. If the actual fair market rents in 20 years turn out to be less than the amount specified in the put renewal option and FM does not exercise the fixed-payment option, X will be able to compel FM to lease the property for rents that are greater than the then fair market rental value. Thus, as a practical matter, the fixed-payment option and put renewal option operate to “collar” the value of the Headlease residual during the primary term.

In addition, X has nominal exposure to FM 's credit under the fixed-payment option and, if exercised, the put renewal term. At the inception of the transaction, X requires FM to invest $15 million of the Headlease prepayment in highly-rated debt securities that will mature in an amount sufficient to fund the fixed amount due under the fixed-payment option, and to pledge these debt securities to X. This arrangement ensures that FM is able to make the payment under the fixed-payment option. Having economically defeased both its rental obligations under the Sublease and its fixed-payment under the fixed-payment option, FM keeps the remaining portion of the Headlease prepayment as its return on the transaction. If FM does not exercise the fixed-payment option and X exercises the put renewal option, X can require FM to purchase a letter of credit guaranteeing the put renewal rents. If FM does not obtain the letter of credit, FM must exercise the fixed-payment option.

For tax purposes, X claims deductions for interest on the loans and for the allocated rents on the Headlease. X includes in gross income the rents received on the Sublease. If the fixed-payment option is exercised, X also includes the option price and recaptures rent deductions taken during the primary Sublease term that are attributable to the postpayment it is no longer required to make.

Law And Analysis

X and FM's allocations of the prepayment and the postpayment for federal income tax purposes meet the uneven rent test contained in proposed § 467 regulations (§ 1.467-3(c)(2)(i)), and under those regulations the Headlease would not be treated as a disqualified leaseback or long-term agreement subject to constant rental accrual. Because this LILO transaction was entered into after June 3, 1996, and on or before May 18, 1999, the provisions of the proposed regulations are available. See §1.467-9(c). For later years, however, final § 467 regulations effective May 18, 1999, treat the prepayment of rent as resulting in a deemed loan from X to FM and require the imputation of interest income to X. § 1.467-4. Moreover, X's rent deduction would be subject to proportional rent rules that reflect the time value of money concept. See § 1.467-2(c).

The substance of a transaction, not its form, governs its tax treatment. Gregory v. Helvering , 293 U.S. 465 [14 AFTR 1191](1935). In Frank Lyon Co. v. United States , 435 U.S. 561, 573 [41 AFTR 2d 78-1142](1978), the United States Supreme Court stated, “In applying the doctrine of substance over form, the Court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed.” The Court evaluated the substance of the transaction in Frank Lyon to determine that it was indeed a sale/leaseback, as it was structured, rather than a financing. The Court subsequently relied on its approach in Frank Lyon to recharacterize a sale and repurchase of federal securities as a loan, finding that the economic realities of the transaction did not support the form chosen by the taxpayer. Nebraska Dep't of Revenue v. Loewenstein, 513 U.S. 123 (1994).

Where parties have in form entered into two separate transactions that result in offsetting obligations, the courts often have collapsed the offsetting obligations and recharacterized the two transactions as a single transaction. In Rogers v. United States , 281 F.3d 1108 [89 AFTR 2d 2002-1115](10 Cir. 2002), the part-owner (Fogelman) of a professional baseball team that was organized as an S corporation borrowed money from the S corporation. The nonrecourse loan was secured by Fogelman's ownership interest in the corporation and his existing option to purchase the rest of the shares from the taxpayer (Kauffman), the other owner of the team. Fogelman also granted the corporation an option to purchase both his shares and his existing option to buy Kauffman's shares. The option price was an amount equal to the outstanding loan balance. The corporation exercised its option immediately but deferred closing until the due date of Fogelman's loan, five months later. On that date, Fogelman transferred his shares in the corporation to the corporation in lieu of its foreclosure on the loan. The corporation claimed that the shares had no value at that time and deducted the loan amount as a bad debt, which was passed through to Kauffman.

The court in Rogers applied the substance over form doctrine to collapse the loan and the option transaction into a redemption of Fogelman's stock in exchange for cash. Fogelman had no incentive to repay the loan because any reduction in the loan balance would reduce the option price. The immediate exercise of the option precluded any attempt by Fogelman to repay the loan and keep the stock. On the basis of those facts, among others, the court held that the substance of the transaction was a sale of Fogelman's stock to the corporation.

In Bussing v. Commissioner, 88 T.C. 449, reconsideration denied, 89 T.C. 1050 (1987), a Swiss subsidiary of a computer leasing company (AG) purchased computer equipment in a sale/leaseback transaction involving a five-year lease. Subsequently, AG purportedly sold the equipment to a domestic corporation (Sutton), which in turn purportedly sold interests in the equipment to the taxpayer (Bussing) and four other individual investors. Bussing acquired his interest in the computer equipment subject to the underlying lease by paying cash, short-term promissory notes, and a long-term promissory note to Sutton. Bussing then leased his interest in the equipment back to AG for nine years. The rents due Bussing from AG equaled Bussing's annual payments on the long-term promissory note to Sutton for the first three years and were supposed to generate nominal annual cash flow thereafter.

The court first disregarded Sutton's participation in the transactions on substance over form grounds. It then held that Bussing's long-term indebtedness also must be disregarded because it was completely offset by AG's rent payments in a “purported sale-leaseback pursuant to which the respective lease and debt obligations flow between only two parties.” Id. at 458. The court stated,

The respective obligations between AG and Bussing cancel each other out. Any possible claim by AG with respect to the note is fully offset by AG's rental obligation to Bussing. . . . Bussing, effectively, will never be required to make any payments on his debt obligation, a feature of the transaction that we believe the parties intended to achieve.

Id.

After collapsing the offsetting loan and lease, the court concluded that Bussing had acquired an interest in a joint venture with AG and the other investors to the extent of his cash payment only.

Courts have similarly disregarded the parties' obligations in purported installment sales where the taxpayer received an installment note that was offset by some other arrangement between the two parties, indicating that the maker of the note would not be called upon to pay the installment obligation. See Rickey v. Commissioner, 502 F.2d 748 [34 AFTR 2d 74-5604] (9 Cir. 1974), aff'g 54 T.C. 680 (1970). Although taxpayers are entitled to arrange the terms of a sale in order to qualify for the installment method, “the arrangements must have substance and must reflect the true situation rather than being merely the formal documentation of the terms of the sale.” Id. at 752-53, quoting 54 T.C. 680 at 694. See also United States v. Ingalls, 399 F.2d 143 [22 AFTR 2d 5299](5 Cir. 1968); Blue Flame Gas Co. v. Commissioner , 54 T.C. 584 (1970); Greenfield v. Commissioner, T.C. Memo. 1982-617; Big “D” Development Corp. v. Commissioner , T.C. Memo. 1971-148, aff'd per curiam , 453 F. 2d 1365 [29 AFTR 2d 72-463](5 Cir.1972).

Similarly, the Headlease and Sublease impose offsetting obligations that must be disregarded, regardless of whether other components of the LILO transaction are respected. During the first 20 years of its term, the Headlease confers to X a right to use the property that is immediately reversed by the Sublease grant to FM of substantially the same right to use property. In the LILO transaction, the Sublease interest retained by FM is of the same nature as the Headlease interest conveyed to X. Because the transfer and retransfer of the right to possess the property for the first 20 years are disregarded as offsetting obligations, the transaction that remains is, at best, a transfer of funds from X to FM in exchange for FM's obligation to repay those funds and provide X the right to begin to lease the property in 20 years.

An analogous situation occurs when the conveyance of property is accompanied by the retention of some interest in the same property. If the interest retained is of substantially the same nature as the interest conveyed, only a future interest is conveyed. In McCully Ashlock v. Commissioner, 18 T.C. 405 (1952), acq., 1952-2 C.B. 1, taxpayer had acquired property through a deed dated June 6, 1945. The seller, however, had retained the right to possession and rentals through August 15, 1947. The court found that taxpayer had acquired only a future interest in the property because “the trustees [sellers] not only retained the rents legally but they also retained control and benefits of ownership.” Id. at 411. Consequently, rentals from the property were income to the seller.

Similarly, in Kruesel v. United States, 63-2 U.S. Tax Cas. (CCH) & 9714 [12 AFTR 2d 5701](D. Minn. 1963), the court concluded that taxpayer had transferred only a future, remainder interest in property and reserved a life estate. The government had unsuccessfully argued that taxpayer had sold its entire interest in the property and the taxpayer's amount realized on the sale included the value of a right to occupancy provided to the taxpayer by the buyer.

In contrast, in Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966), acq., 1967-2 C.B.1, the court held that a sale of property accompanied by the reservation of a right of occupancy did not result in the transfer of only a future interest because the seller's right of occupancy was in the nature of a leasehold interest, because the purchaser acquired the benefits and burdens of ownership of the property.

Alstores can be distinguished from McCully Ashlock and Kruesel. McCully Ashlock and Kruesel conclude that where a retained interest is of the same nature as the interest conveyed, only a future interest has been transferred. In Alstores, the interests were not of the same nature.

Similarly, the LILO transaction is distinguishable from the transaction involved in Comdisco, Inc. v. Commissioner, 756 F.2d 569 [55 AFTR 2d 85-1006](7 Cir. 1985). In that case, equipment was subject to end user leases, and the lessor of that equipment assigned an interest to taxpayer in a transaction designed to give the taxpayer investment tax credits. The taxpayer's entitlement to the credits depended on whether it had the status of lessee/sublessor. In concluding that it did, the court noted a number of factors that supported taxpayer's claim that it had acquired a leasehold interest. The taxpayer was obligated to the lessor in the event of a default by the sublessee. The taxpayer relet certain equipment after one sublease had expired. In connection with another sublease, the taxpayer was responsible for rent to its assignor in excess of amounts paid by the sublessee directly to the assignor. The court also emphasized the regulatory restrictions on direct leases between the assignor and the end users. Id. at 576-77. Unlike Comdisco, in the LILO transaction the headlessor and the sublessee are the same party. Further, in the LILO transaction the headlessee/sublessor is not materially exposed to the risk that the sublessee will fail to make rent payments.

Section 162(a)(3) permits a deduction for rentals and other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property. Because X does not acquire a current leasehold interest in the property, it is not entitled to current deductions for rent. The $29 million “equity” portion of the Headlease prepayment is, effectively, a payment for at most X's right under the Headlease to lease the property 20 years hence for a term of 20 years. (Economically, $29 million is an overpayment for the value of any right that X obtains to lease the property in the future. X was willing to overpay in this manner, however, in order to induce FM to participate in the transaction.). In accordance with § 467, the $29 million “equity” portion of the Headlease prepayment is deductible over the 20-year residual term of the Headlease (the 10-year put renewal term and the 10-year Ashirttail@ period). Alternatively, in the event FM exercises its fixed-price option at the end of the primary term of the Sublease, X will have gain or loss equal to the difference between the option price and X's cost of acquiring a right to the Headlease residual term. Section 1001.

The remainder of the Headlease prepayment, $60 million, must be disregarded, because the “loans” that purportedly finance this portion of the Headlease prepayment are without substance. In Bridges v. Commissioner, 39 T.C. 1064, aff'd 325 F.2d 180 [12 AFTR 2d 6037] (4 Cir. 1963), taxpayer “borrowed” funds from banks and used the funds to purchase Treasury notes, which the banks held as collateral and ultimately sold to satisfy taxpayer's debts. The court's rationale for disallowing taxpayer's deductions of prepaid interest is equally applicable here:

[P]etitioner at no time had the uncontrolled use of any additional money, of the bonds, or of the interest on the bonds. He assumed no risk of a rise or fall in the market price of the bonds and could not take advantage of such. His payment to the bank was not for the use or forbearance of money; it was for the purchase of a rigged sales price for the bonds and for a tax deduction. Petitioner incurred no genuine indebtedness, within the meaning of the statute, and as a payment of interest, this transaction was also a sham.

Id. at 1078-79. Neither X nor FM obtain use of the “borrowed” funds. The “loans” purportedly are made to finance X's acquisition of the Headlease interest. But that leasehold interest is substantially offset by an interdependent Sublease with the Headlessor. What remains can only be enjoyed after 20 years and after the loans have been “repaid” using “rents” from a Sublease that itself lacks substance. Under the circumstances, the loans are disregarded.

Although this ruling refers to a foreign municipality and its property, the analysis and holding apply as well to LILO transactions that involve or include domestic tax-exempt or tax-indifferent entities.

Holding

A taxpayer may not deduct currently, under §§ 162 and 163, rent or interest paid or incurred in connection with a LILO transaction that properly is characterized as conferring only a future interest in property.

Where appropriate, the Service will continue to disallow the tax benefits claimed in connection with LILO transactions upon other grounds, including that the substance over form doctrine requires their recharacterization as financing arrangements and that they are to be disregarded for lack of economic substance.

Effect On Other Documents

Rev. Rul. 99-14, 1999-1 C.B. 835, is modified and superseded.

Drafting Information

The principal author of this revenue ruling is John Aramburu of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling contact Mr. Aramburu at (202) 622-4960 (not a toll-free call).

Notice 2002-70, 2002-2 CB 765, 10/15/2002, IRC Sec(s). 6011

Tax shelters—producer-owned reinsurance companies.

Headnote:

[CAUTION: This Notice has been modified by Notice 2004-65, 2004-41 IRB 599.]

IRS is aware of transactions involving taxpayers who are service providers, car dealers, lenders, or retailers who offer their customers insurance contracts on products sold to cover loss, breakage, or payment obligations. Taxpayer acts as agent for unrelated insurance co., who then reinsures policies through wholly-owned foreign corp., which typically elects to be treated as domestic corp under Code Sec. 953(d); . Foreign corp. will then assert it is entitled to various tax benefits. IRS notes that it will challenge this type of transaction because it is using reinsurance agreements to divert income properly attributable to taxpayer to wholly-owned reinsurance co., subject to little or no income tax exposure. Transactions that are the same or substantially similar to these may be subject to Code Sec. 6011; disclosure requirements, Code Sec. 6111; shelter registration requirements, and Code Sec. 6112; list maintenance requirements, and taxpayers participating are subject to various penalties.

Reference(s): ¶ 60,114.02; ¶ 61,114; ¶ 61,124; Code Sec. 6011; Code Sec. 6111; Code Sec. 6112;

Full Text:

The Internal Revenue Service and Treasury Department have become aware of a type of transaction, described below, that is being used by taxpayers to shift income from taxpayers to related companies purported to be insurance companies that are subject to little or no U.S. federal income tax. This notice alerts taxpayers and their representatives that these transactions often do not generate the federal tax benefits that taxpayers claim are allowable for federal income tax purposes. This notice also alerts taxpayers, their representatives, and promoters of these transactions, to certain reporting and record keeping obligations and penalties that they may be subject to with respect to these transactions.

The transaction generally involves a taxpayer (“Taxpayer”) (typically a service provider, automobile dealer, lender, or retailer) that offers its customers the opportunity to purchase an insurance contract through Taxpayer in connection with the products or services being sold. The insurance provides coverage for repair or replacement costs if the product breaks down or is lost, stolen, or damaged, or coverage for the customer's payment obligations in case the customer dies, or becomes disabled or unemployed.

Taxpayer offers the insurance to its customers by acting as an insurance agent for an unrelated insurance company (“Company X”). Taxpayer receives a sales commission from Company X equal to a percentage of the premiums paid by Taxpayer's customers. Taxpayer forms a wholly-owned corporation (“Company Y”), typically in a foreign country, to reinsure the policies sold by Taxpayer. Promoters sometimes refer to these companies as producer owned reinsurance companies or “PORCs”. If Company Y is a foreign corporation, it typically elects to be treated as a domestic insurance company under § 953(d) of the Internal Revenue Code. Company Y takes the position that it is entitled to the benefits of § 501(c)(15) (providing that non-life insurance companies are tax exempt if premiums written for the taxable year do not exceed $350,000), § 806 (providing a deduction for certain life insurance companies with life insurance company taxable income not in excess of $15,000,000), or § 831(b) (allowing qualifying non-life insurance companies whose net written premiums are between $350,000 and $1,200,000 to elect to be taxed solely on investment income).

Taxpayer receives premiums from its customers and remits those premiums (typically net of its sales commission) to Company X. Company X pays any claims and state premium taxes due and retains an amount from the premiums received from Taxpayer. Under Company Y's reinsurance agreement with Company X, Company Y reinsures all insurance policies that Taxpayer sells to its customers. Company X transfers the remainder of the premiums to Company Y as reinsurance premiums.

Analysis

Many of the transactions described in this Notice have been designed to use a reinsurance arrangement to divert income properly attributable to Taxpayer to Company Y, Taxpayer's wholly-owned reinsurance company that is subject to little or no federal income tax. The Service intends to challenge the purported tax benefits from these transactions on a number of grounds.

First, depending upon the facts and circumstances, the Service may assert that Company Y is not an insurance company for federal income tax purposes. For federal income tax purposes, an insurance company is a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. §1.801-3(a) of the Income Tax Regulations; § 816(a) (which provides that a company will be treated as an insurance company for federal income tax purposes only if “more than half of the business” of that company is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies). While a taxpayer's name, charter powers, and state regulation help to indicate the activities in which it may properly engage, whether the taxpayer qualifies as an insurance company for tax purposes depends on its actual activities during the year. Inter-American Life Ins. Co. v. Commissioner, 56 T.C. 497, 506-08 (1971), aff'd per curiam, 469 F.2d 697 [31 AFTR 2d 73-412](9 Cir. 1972) (taxpayer whose predominant source of income was from investments did not qualify as an insurance company); see also Bowers v. Lawyers Mortgage Co., 285 U.S. 182, 188 [10 AFTR 1604] (1932). To qualify as an insurance company, a taxpayer “must use its capital and efforts primarily in earning income from the issuance of contracts of insurance.” Indus. Life Ins. Co. v. United States, 344 F. Supp. 870, 877 [29 AFTR 2d 72-1016](D. S.C. 1972), aff'd per curiam, 481 F.2d 609 [32 AFTR 2d 73-5273](4 Cir. 1973). To determine whether Company Y qualifies as an insurance company, all of the relevant facts will be considered, including but not limited to, the size and activities of any staff, whether Company Y engages in other trades or businesses, and its sources of income. See generally Lawyers Mortgage Co. at 188-90; Indus. Life Ins. Co., at 875-77; Cardinal Life Ins. Co. v. United States, 300 F. Supp. 387, 391-92 [23 AFTR 2d 69-1427](N.D. Tex. 1969), rev'd on other grounds, 425 F. 2d 1328 [25 AFTR 2d 70-1246](5 Cir. 1970); Serv. Life Ins. Co. v. United States, 189 F. Supp. 282, 285-86 [6 AFTR 2d 5481](D. Neb. 1960), aff'd on other grounds , 293 F.2d 72 [8 AFTR 2d 5135](8 Cir. 1961); Inter-Am. Life Ins. Co., at 506-08 ; Nat'l. Capital Ins. Co. of the Dist. of Columbia v. Commissioner, 28 B.T.A. 1079, 1085-86 (1933).

If Company Y is not an insurance company, it is not entitled to the benefits of §§ 501(c)(15), 806, or 831(b). Further, if Company Y is a foreign corporation and is not an insurance company, any election Company Y made under § 953(d) is not valid and Company Y will be treated as a controlled foreign corporation as defined in § 957. In such a case, Taxpayer will be treated as a U.S. shareholder of Company Y and generally will include in its gross income on a current basis any subpart F income of Company Y. See § 951(a) and (b). In addition, Company Y will not qualify for the exceptions from subpart F income under '' 953(a)(2) and 954(i) for certain insurance income because those exceptions are only available to a foreign corporation that, among other requirements, is engaged in the insurance business and would be subject to tax under subchapter L if such corporation were a domestic corporation. See § 953(e)(3)(C).

Second, the Service may apply §§482 or 845 to allocate income from Company Y to Taxpayer if necessary clearly to reflect the income of Taxpayer and Company Y. Section 482 provides the Secretary with authority to allocate gross income, deductions, credits or allowances among persons owned or controlled directly or indirectly by the same interests, if such allocation is necessary to prevent evasion of taxes or clearly to reflect income. The § 482 regulations provide that in determining the taxable income of a controlled person, the standard to be applied is that of a person dealing at arm's length with an uncontrolled person. § 1.482-1(b)(1). Section 482 may apply to a transaction between two or more controlled persons notwithstanding that an uncontrolled person participates in the transaction as an intermediary. See GAC Produce Co. v. Commissioner, T.C.M. 1999-134. If, as a result of the reinsurance transaction, Taxpayer's income is not consistent with the arm's length standard, then § 482 authorizes the Secretary to allocate income from Company Y to Taxpayer. Section 845(a) allows the Service to reallocate income, deductions, assets, reserves, credits, and other items between two or more related parties who are parties to a reinsurance agreement. Thus, such items may be reallocated from Company Y to Taxpayer under the authority of § 845(a).

Third, in appropriate cases, the Service may disregard the insurance and reinsurance arrangements, and thereby require Taxpayer to recognize an additional portion of premiums received from its customers as its income, if the arrangements are shams in fact or shams in substance. See Kirchman v. Commissioner, 862 F.2d 1486, 1492 [63 AFTR 2d 89-588](11 Cir. 1989). Courts have distinguished between “shams in fact” where the reported transactions never occurred and “shams in substance” which actually occurred but lack the substance their form represents. ACM Partnership v. Commissioner, 157 F.3d 231, 247 n. 30 [82 AFTR 2d 98-6682] (3 Cir. 1998), cert. denied, 526 U.S. 1017 (2002) (citations omitted). In determining whether a transaction constitutes a sham in substance, both a majority of the Courts of Appeals and the Tax Court consider two related factors, economic substance apart from tax consequences, and business purpose. See ACM Partnership; Karr v. Commissioner, 924 F.2d 1018, 1023 [67 AFTR 2d 91-653](11 Cir. 1991), cert. denied, 502 U.S. 1082 (1992); James v. Commissioner, 899 F.2d 905, 908-09 [65 AFTR 2d 90-1045](10 Cir. 1990); Shriver v. Commissioner, 899 F.2d 724, 727 [65 AFTR 2d 90-994] (8 Cir. 1990); Rose v. Commissioner , 868 F.2d 851, 853 [63 AFTR 2d 89-776](6 Cir. 1989); Kirchman. Although a taxpayer has the right to arrange its affairs to reduce its tax liability, the substance of a transaction must govern its tax consequences regardless of the form in which the transaction is cast. See Gregory v. Helvering, 293 U.S. 465, 469 [14 AFTR 1191](1935). If the transactions involving Taxpayer, Company X, and Company Y are disregarded, the income of Company Y is income of Taxpayer. See Wright v. Commissioner, T.C.M. 1993-328.

Transactions that are the same as, or substantially similar to, the transaction described in this Notice that involve taxpayers claiming entitlement to the benefits of 501(c)(15), 806, or 831(b) are identified as listed transactions for purposes of 1.6011-4T(b)(2) of the temporary Income Tax Regulations and § 301.6111-2T(b)(2) of the temporary Procedure and Administration Regulations. See also § 301.6112-1T, A-4. Independent of their classification as “listed transactions” for purposes of §§ 1.6011-4T(b)(2) and 301.6111-2T(b)(2), transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the disclosure requirements of § 6011, the tax shelter registration requirements of § 6111, or the list maintenance requirements of § 6112 (§§1.6011-4T, 301.6111-1T, 301.6111-2T and 301.6112-1T, A-3 and A-4).

Persons who are required to satisfy the registration requirement of § 6111 with respect to the transactions described in this Notice and who fail to do so may be subject to the penalty under § 6707(a). Persons who are required to satisfy the list-keeping requirement of § 6112 with respect to the transactions described in this notice and who fail to do so may be subject to the penalty under § 6708(a). In addition, the Service may impose penalties on participants in these transactions or substantially similar transactions involving taxpayers claiming entitlement to the benefits of §§ 501(c)(15), 806, or 831(b) or, as applicable, on persons who participate in the promotion or reporting of such transactions, including the accuracy-related penalty under § 6662, the return preparer penalty under § 6694, the promoter penalty under § 6700, and the aiding and abetting penalty under § 6701.

The principal authors of this Notice are John Glover of the Office of Associate Chief Counsel (Financial Institutions and Products) and Theodore Setzer and Sheila Ramaswamy of the Office of Associate Chief Counsel (International). For further information regarding this notice contact Mr. Glover at (202) 622 -3970 or Mr. Setzer or Ms. Ramaswamy (202) 622-3870 (not a toll-free call).

Notice 2003-55, 2003-2 CB 395, 07/22/2003, IRC Sec(s). 482

Allocation of income and deductions—shifting of deductions.

Headnote:

IRS warned participants in various types of lease stripping transactions that it intends to challenge strips under various IRC provisions, and that certain penalties might apply. Notice 95-53, 1995-2 CB 334, is modified and superseded.

Reference(s): ¶ 4825.07(38); Code Sec. 482;

Full Text:

Notice 95-53, 1995-2 C.B. 334, addresses certain tax consequences of lease strips or stripping transactions. Lease strips are transactions in which one participant claims to realize rental or other income from property and another participant claims the deductions related to that income (for example, depreciation or rental expenses). Lease strips may take a variety of forms, including, but not limited to, those in the following examples.

(a) A lease strip effected through a transferred basis transaction. In exchange for consideration, one participant sells, assigns, or otherwise transfers (“assigns”) the right to receive future payments under a lease of tangible property, and treats the amount realized from the assignment as its current income. The participant later transfers the property (subject to the lease) in a transaction intended to qualify as a transferred basis transaction, such as a transaction described in § 351 of the Internal Revenue Code. The transferee often is not identified until after the transferor has assigned the future payments. Typically, the transferor (or a partner in a partnership that is a transferor) is generally not subject to U.S. federal income tax or has available net operating losses, and the equity of the transferee is owned predominantly by persons other than the transferor.

(b) A lease strip effected through a transfer of an interest in a partnership (or other pass-through entity). In exchange for consideration, the partnership assigns its right to receive future payments under a lease of tangible property and allocates the amount realized from the assignment to its current partners (many of whom are generally not subject to federal income tax or have available net operating losses). The partnership retains the underlying property, and thereafter, there is a transfer or redemption of a partnership interest by one or more partners to whom the partnership allocated the income that it reported from the assignment. The transfer or redemption is structured to avoid a reduction in the basis of partnership property.

(c) A lease strip effected by a single participant. A participant assigns its right to receive future payments under a lease of tangible property at a time when that participant is not subject to U.S. federal income tax or in a manner in which the realized amount is not includible in computing the participant's U.S. federal income tax and that same participant or a successor claims deductions related to that income for purposes of U.S. federal income tax.

In addition to transactions described above, this notice applies to lease strips involving licenses of intangible property, service contracts, leaseholds or other non-fee interests in property, and the prepayment, front-loading, or retention (rather than assignment) of rights to receive future payments.

Discussion

The Internal Revenue Service has concluded that lease strips improperly separate income from related deductions and generally do not produce the tax consequences desired by the participants. Depending on the facts of a particular case, the Service may apply one or more Code sections or theories to challenge a lease strip. For example, the Service may apply §§ 165, 269, 382, 446(b), 701, or 704. The Service also may challenge certain assignments or accelerations of future payments as financings. Finally, the Service, as appropriate, may assert that there is no valid partnership or may apply various judicial doctrines, such as the doctrines of assignment-of-income, business purpose, substance-over-form, step transaction, or sham.

Recently, the Court of Appeals for the District of Columbia Circuit held that the partnership used in a lease strip was not a valid partnership because the participants did not join together for a non-tax business purpose. Andantech L.L.C. v. Commissioner, Nos. 02-1213; 02-1215, [91 AFTR 2d 2003-2623](D.C. Cir. June 17, 2003), 2003 U.S. App. LEXIS 11908, aff'g in part and remanding for reconsideration of other issues T.C. Memo 2002-97 (2002). Also, in Nicole Rose v. Commissioner, 320 F.3d 282 [90 AFTR 2d 2002-7702](2d Cir. 2002), aff'g per curiam 117 T.C. 328 (2001), the United States Court of Appeals for the Second Circuit upheld the Tax Court's determination that a lease transfer did not have economic substance.

Transactions that are the same as, or substantially similar to, the lease strips described in this notice are identified as “listed transactions” for purposes of § 1.6011-4(b)(2) of the Income Tax Regulations and §§ 301.6111-2(b)(2) and 301.6112-1(b)(2) of the Procedure and Administration Regulations. Independent of their classification as “listed transactions” for purposes of §§ 1.6011-4(b)(2), 301.6111-2(b)(2), and 301.6112-1(b)(2), transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the disclosure requirements of § 6011, the tax shelter registration requirements of § 6111, or the list maintenance requirements of § 6112 (§§ 1.6011-4, 301.6111-1T, 301.6111-2, and 301.6112-1). Persons required to register these tax shelters who have failed to register the shelters may be subject to the penalty under § 6707(a). Persons required to maintain a list of investors under § 6112 may be subject to the penalty under § 6708(a) if the requirements of § 6112 are not satisfied.

Finally, the Service may impose penalties on participants in lease strip transactions or, as applicable, on persons who participate in the promotion or reporting of lease strips, in

In addition, the Service is currently evaluating other situations in which tax benefits are claimed as a result of transactions in which the ownership of property has been separated from the right to income from the property. For example, the Service is evaluating situations in which, in exchange for consideration, one participant assigns its interest in property but retains the right to income from the property, and, by allocating all of its basis to the transferred property and none to the retained future payments, the transferor claims a loss on the transfer.

This Notice 2003-55 modifies and supersedes Notice 95-53.

Drafting Information

The principal author of this notice is Pamela Lew of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this notice, contact Ms. Lew at (202) 622-3950 (not a toll-free call).

Notice 2009-7, 2009-3 IRB 312, 12/29/2008, IRC Sec(s). 6111

Reportable and list transactions—transactions of interest—potential for abuse and tax avoidance—controlled foreign corps.—income inclusions.

Headnote:

IRS has become aware of transactions where U.S. taxpayer, which owns CFCs that hold stock of lower-tier CFC through domestic partnership, takes position that subpart F income of lower-tier CFC or amount determined under Code Sec. 956(a); related to U.S. property held by lower-tier CFC doesn't result in Code Sec. 951(a); income inclusions for U.S. taxpayer. IRS and Treas. Dept. believe transaction has potential for tax avoidance or evasion, but lack enough information to determine whether transaction should be identified specifically as tax avoidance transaction. Transactions same or substantially similar to those described are identified as “of interest” for purposes of Reg § 1.6011-4(b)(6) , Code Sec. 6111; and Code Sec. 6112; , effective 12/29/2008. Persons entering same, and material advisors making tax statement with respect thereto, on or after 11/2/2006, are subject to disclosure and list maintenance requirements.

Reference(s): ¶ 61,115.01(30); ; ¶ 61,125.01(10); Code Sec. 6111; Code Sec. 6112;

Full Text:

The Internal Revenue Service (IRS) and the Treasury Department are aware of a type of transaction, described more fully below, in which a U.S. taxpayer that owns controlled foreign corporations (CFCs) that hold stock of a lower-tier CFC through a domestic partnership takes the position that subpart F income of the lower-tier CFC or an amount determined under section 956(a) of the Internal Revenue Code (Code) related to holdings of United States property by the lower-tier CFC does not result in income inclusions under section 951(a) for the U.S. taxpayer. The IRS and Treasury Department believe this transaction (which includes taking the position that the U.S. taxpayer has no income inclusion under section 951(a)) has the potential for tax avoidance or evasion, but lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction. This notice identifies this transaction and substantially similar transactions as transactions of interest for purposes of § 1.6011-4(b)(6) of the Income Tax Regulations and sections 6111 and 6112 of the Code. This notice also alerts persons involved in these transactions to certain responsibilities that may arise from their involvement with these transactions.

Facts

In a typical transaction, a U.S. taxpayer (Taxpayer) wholly owns two CFCs, (CFC1 and CFC2). CFC1 and CFC2 are partners in a domestic partnership (USPartnership). USPartnership owns 100 percent of the stock of another CFC (CFC3). Some or all of the income of CFC3 is subpart F income (as defined in section 952). As part of the transaction, Taxpayer takes the position that the subpart F income of CFC3 is currently included in the income of USPartnership (which is not subject to U.S. tax) and is not included in the income of Taxpayer. The result of the claimed tax treatment is that income that would otherwise be taxable currently to Taxpayer under subpart F of the Code is not taxable to Taxpayer because of the interposition of a domestic partnership in the CFC structure. Without the interposition of USPartnership, the section 951(a) inclusion resulting from the subpart F income of CFC3 would be taxable currently to Taxpayer. In some variations of the transaction, there may be more than one person that owns the stock of CFC1 and/or CFC2, USPartnership may own less than all of the stock of CFC3, a domestic trust may be used instead of a domestic partnership, or the section 951(a) inclusion amount may result from an amount determined under section 956.

The IRS and Treasury Department are concerned that taxpayers are taking the position that structures described in this notice result in no income inclusion to Taxpayer under section 951. Therefore the IRS and Treasury Department are identifying as transactions of interest such structures with respect to which the Taxpayer takes the position that there is no income inclusion to Taxpayer under section 951, as well as substantially similar transactions. The IRS and Treasury Department believe that the position there is no income inclusion to Taxpayer under section 951 is contrary to the purpose and intent of the provisions of subpart F of the Code.

Transaction Of Interest

Effective Date

Transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as transactions of interest for purposes of § 1.6011-4(b)(6) and sections 6111 and 6112 effective December 29, 2008, the date this notice was released to the public. Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in 1.6011-4. Material advisors who make a tax statement on or after November 2, 2006, with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under sections 6111 and 6112. See § 1.6011-4(h) and §§ 301.6111-3(i) and 301.6112-1(g) of the Procedure and Administration Regulations.

Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the requirements of sections 6011, 6111, or 6112, or the regulations thereunder. When the IRS and Treasury Department have gathered enough information to make an informed decision as to whether these transactions are a tax avoidance type of transaction, the IRS and Treasury Department may take one or more administrative actions, including removing the transactions from the transactions of interest category in published guidance, designating the transactions as a listed transaction, or providing a new category of reportable transactions. In the interim, in appropriate situations, the IRS may challenge the taxpayer's position taken as part of these transactions under subpart F, subchapter K, or other provisions of the Code or under judicial doctrines such as sham transaction, substance over form, and economic substance.

Participation

Under § 1.6011-4(c)(3)(i)(E), Taxpayer and USPartnership are participants in this transaction for each year in which their respective returns reflect tax consequences or a tax strategy described in this notice.

Time for Disclosure

See § 1.6011-4(e) and § 301.6111-3(e).

Material Advisor Threshold Amount

The threshold amounts are the same as those for listed transactions. See § 301.6111-3(b)(3)(i)(B).

Penalties

Persons required to disclose these transactions under § 1.6011-4 who fail to do so may be subject to the penalty under section 6707A. Persons required to disclose these transactions under section 6111 who fail to do so may be subject to the penalty under section 6707(a). Persons required to maintain lists of advisees under section 6112 who fail to do so (or who fail to provide such lists when requested by the Service) may be subject to the penalty under section 6708(a). In addition, the Service may impose other penalties on parties involved in these transactions or substantially similar transactions, including the accuracy-related penalty under section 6662 or section 6662A.

Drafting Information

The principal author of this notice is John H. Seibert of the Office of Associate Chief Counsel (International). For further information regarding this notice contact Mr. Seibert at (202) 622-3860 (not a toll-free call).

Notice 2010-41, 2010-22 IRB 715, 05/14/2010, IRC Sec(s). 951

Amounts included in gross income of U.S. shareholders—definition of domestic partnership.

Headnote:

After determining that general definition of domestic partnership under Code Sec. 7701(c)(4); is “manifestly incompatible” with intent of Code Sec. 951; , IRS stated that in upcoming regs it intends to classify certain domestic partnerships as foreign, solely for purpose of identifying which U.S. shareholder is required to include amounts in gross income under Code Sec. 951(a); . Regs will treat domestic partnership as foreign under certain narrow conditions.

Reference(s): ¶ 9515.01(22); Code Sec. 951;

Full Text:

1. Overview

The Treasury Department and Internal Revenue Service (IRS) intend to issue regulations that will classify certain domestic partnerships as foreign for purposes of identifying the United States shareholders (as defined in § 951(b) of the Internal Revenue Code (Code)) of a controlled foreign corporation (as defined in § 957(a)) that are required to include in gross income the amounts specified under § 951(a) of such controlled foreign corporation. The regulations to be issued pursuant to this notice shall apply to taxable years of a domestic partnership ending on or after May 14, 2010.

2. Transaction At Issue

On December 29, 2008, the Treasury Department and the IRS issued Notice 2009-7, 2009-1 C.B. 312, identifying the following transaction (and substantially similar transactions) as a transaction of interest for purposes of §1.6011-4(b)(6) and §§ 6111 and 6112 of the Code. A United States taxpayer (Taxpayer) wholly owns two controlled foreign corporations (CFC1 and CFC2), each of which owns 50 percent of another controlled foreign corporation (CFC3) through a domestic partnership. CFC3 has amounts described in § 951(a)(1). Taxpayer takes the position that it does not have an income inclusion under § 951(a) with respect to CFC3 because the domestic partnership is the first United States person in the chain of ownership of CFC3. As stated in Notice 2009-7, the Treasury Department and IRS believe that Taxpayer's position is contrary to the purpose and intent of § 951 of the Code.

3. Background

Section 951(a) provides that if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year, then each United States shareholder (as defined in § 951(b)) of such corporation that owns, within the meaning of § 958(a), stock in the corporation on the last day in such year on which it is a CFC must include in gross income its pro rata share of the corporation's subpart F income (as defined in § 952) as well as any amount determined under § 956 with respect to such shareholder. See also § 951(a)(1)(A)(ii) and (iii) for other required inclusions.

Section 951(b) defines a United States shareholder, with respect to any foreign corporation, as a United States person (as defined in § 957(c)) that owns (within the meaning of § 958(a)) or is considered as owning under § 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

With certain modifications, § 957(c) defines a United States person by reference to § 7701(a)(30). Section 7701(a)(30)(B) defines a United States person to include a domestic partnership. Section 7701(a)(5) defines the term foreign when applied to a corporation or partnership as a corporation or partnership that is not domestic. Section 7701(a)(4) provides that the term domestic when applied to a corporation or partnership means created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations. However, § 7701(a) provides that any general definition included therein does not apply where such definition is manifestly incompatible with the intent of the relevant Code provision.

4. Regulations Concerning The Definition Of A Foreign Partnership Under Section 7701

If the general definition of a United States person provided by § 7701(a)(30)(B) (which incorporates the general definition of a domestic partnership under § 7701(a)(4)) applies to the facts described above in Section 2 (and in Notice 2009-7), the domestic partnership is the United States shareholder required to include in gross income the amounts determined under § 951(a) with respect to CFC3. However, the domestic partnership's gross income inclusion may have little or no tax consequences, depending on the treatment of each partner's (CFC1 and CFC2) distributive share of such income. As stated in Notice 2009-7, the Treasury Department and the IRS believe that the Taxpayer's position in the transaction described therein is contrary to the purpose and intent of § 951. Therefore, consistent with § 7701(a), the Treasury Department and the IRS have determined that the general definition of a domestic partnership under § 7701(a)(4), in the case of certain partnerships owned wholly or partly by foreign corporations, is manifestly incompatible with the intent of § 951.

.01. Domestic Partnership Treated As Foreign For Certain Purposes

.01. The Treasury Department and the IRS intend to issue regulations that, under certain circumstances, will classify an otherwise domestic partnership as foreign solely for purposes of identifying the United States shareholders of a CFC required to include in gross income the amounts determined under § 951(a) with respect to such CFC. Specifically, the regulations to be issued shall treat a domestic partnership as foreign for this purpose if the following conditions are satisfied:

1. The partnership is a United States shareholder of a foreign corporation that is a CFC (within the meaning of § 957(a) or 953(c)); and

2. If the partnership were treated as foreign,

a. That foreign corporation would continue to be a CFC; and

b. At least one United States shareholder of the CFC,

i. Would be treated under § 958(a) as indirectly owning stock of the CFC owned by the partnership that is indirectly owned by a foreign corporation; and

ii. Would be required to include an amount in gross income under § 951(a) with respect to the CFC.

The regulations to be issued will provide similar results in the case of tiered-partnership structures.

.02. Scope Of Treatment As A Foreign Partnership

.02. The regulations to be issued shall classify a domestic partnership described in § 4.01 of this notice as foreign solely for purposes of identifying the United States shareholders of a CFC required to include in gross income the amounts determined under § 951(a) with respect to such CFC. Therefore, a domestic partnership to which the regulations to be issued apply shall continue to be classified as domestic for all other purposes of the Code. For example, the regulations to be issued shall not otherwise affect the classification of the partnership as domestic for purposes of determining the source of income and expenses, the definition of “United States property” under § 956(c)(1)(C), and the application of § 1248(a). Similarly, the partnership remains a domestic partnership for purposes of determining its information reporting obligations, including the filing of a Form 1065, U.S. Return of Partnership Income, and Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations .

The following demonstrates the application of the regulations described in this Notice to the facts described above in Section 2. Under the regulations to be issued, the domestic partnership described in Notice 2009-7 and in Section 2 above would be treated as foreign because the partnership would be a United States shareholder of a foreign corporation that is a CFC (CFC3) if the regulations to be issued did not apply; and if the domestic partnership were treated as foreign, (1) CFC3 would continue to be a CFC, and (2) under § 958(a) Taxpayer (a United States shareholder of CFC3) would be treated as indirectly owning the stock of CFC3 owned by the partnership that is indirectly owned by CFC1 and CFC2, and would be required to include in gross income the amounts determined under § 951(a) with respect to CFC3. The result would be the same if the Taxpayer were a partner in the partnership (in addition to CFC1 and CFC2), or also owned directly stock of CFC3.

5. Effect On Other Documents

Notice 2009-7 shall continue to apply, as appropriate.

6. Effective Date

The regulations to be issued as described in this notice shall apply to taxable years of a domestic partnership ending on or after May 14, 2010. No inference is intended as to the treatment of a domestic partnership for any taxable year ending before May 14, 2010. As stated in Notice 2009-7, the IRS may challenge the positions taken by taxpayers with respect to such transactions, including under the provisions of subpart F and subchapter K of the Code, or under judicial doctrines including the sham transaction, substance over form, and economic substance doctrines.

7. Drafting Information

For further information regarding this notice, contact Susan E. Massey at (202) 622-3840 (not a toll-free call).

IRS Tax Attorney

Saturday, October 6, 2012

Economic substance doctrine

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