The legal right of a taxpayer to reduce or eliminate the amount of other taxes by means permitted by law cannot be challenged. * * * But the question of whether what was done, apart from tax reasons, was what the law intended. The IRC defines the doctrine of economic substance as “the doctrine of the common law, according to which. Transactions are not allowed if they have no economic substance or commercial purpose. [3] According to the Code, the doctrine applies only to transactions “related to a trade, business or activity for the purpose of generating income.” [4] Although the doctrine has been codified in IRC § 7701(o), common law principles, which were developed long before their codification, remain relevant because these common law principles – even under the law – determine whether or not there is economic substance. [5] In early 2019, regulations came into force in major offshore jurisdictions requiring companies engaged in certain types of activities to demonstrate adequate economic substance in that country. This portfolio analyzes the doctrine of economic substance and the associated judicial anti-abuse doctrines. Bloomberg Tax Portfolio, The Economic Substance Doctrine, No. 508, analyzes the “doctrine of economic substance” as codified in Section 7701(o) of the Internal Revenue Code. Section 7701(o) defines the “doctrine of economic substance” as the “common law” developed by the courts to prohibit tax benefits for tax-based transactions that did not have a “commercial purpose” or “economic substance”. Prior to codification, the existence of a “commercial object” or “economic substance” in certain channels was sufficient to maintain the tax advantages of a transaction (the “severance” test); In other circuits, both had to be present (the “subjunctive test”). Sometimes the doctrine of economic substance was used in conjunction with the doctrine of commercial object. The latter, a subjective doctrine, consists of analyzing the purpose of the transaction in order to determine whether the taxpayer intended the transaction to serve a useful non-tax purpose. Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Reconciliation Act of 2010, as amended, in combination with the Patient Protection and Affordable Care Act, JCX-18-10, 21 March 2010, p.

143. [8] See Bank of New York Mellon Corp. v. C.I.R., 801 F.3d 104, 115 (2d Cir. 2015) (citing Gilman v. Comm`r, 933 F.2d 143, 147–48 (2d Cir.1991)) (judgment on transactions that took place prior to IRC, but noting that, according to common law principles of economic substance, the elements of the test are always “1”), if the taxpayer had an objectively reasonable expectation of profits, in addition to the tax benefits, the transaction; and (2) whether the taxpayer had a non-tax subjective business purpose at the time the transaction was entered into. »); see also ACM P`ship v. C.I.R., 157 F.3d 231, 247 (3d Cir. 1998). For the calculation of profit potential, fees and other transaction costs should be taken into account as expenses when determining pre-tax profit. In addition, I.R.S. is authorized to issue regulations under which foreign taxes are treated as an expense in appropriate cases when determining the benefit of input tax. It should be noted that factors other than profit potential may demonstrate that a transaction results in a material change in the taxpayer`s economic circumstances or that the taxpayer has a material non-federal tax objective in entering into such a transaction.

The provision does not require or set a fixed minimum return that satisfies the profit potential test. We can advise you individually on the use of the economic substance test in your business, whether the test is likely to be passed and what changes to your policies and procedures may be necessary to reduce the risk of failing the test. Crown dependencies, as well as other offshore jurisdictions, including the British Virgin Islands and the Cayman Islands, have introduced a legal substance requirement for companies doing business in or through their jurisdiction. The legal requirement takes the form of an economic substance test that allows companies to demonstrate that their profits in Crown Dependencies are commensurate with their economic activities and significant economic presence in those countries. Since that case, the courts have attempted to adopt legitimate tax planning (i.e., those with substance) of abusive structures that correspond to the letter of the law but contradict its spirit. The principle has been applied in various iterations and has evolved over the years: while all companies concerned are required to file a notification with details of their activities, an enterprise falling within the scope only has to comply with the economic substance test if it carries out a “relevant activity”. The relevant activities in each jurisdiction are as follows: If tax benefits are denied by the IRS for lack of economic substance pursuant to Section 6662(b)(6), the traditional 20% penalty may apply for insufficient payment of tax. [9] However, if “the relevant facts relating to the [economic substance of the transaction] are not adequately disclosed at the time of restitution or seizure for restitution”, the penalty increases from 20% to 40%. [10] This can be a high price. A certain degree of uncertainty arose from the different applications of the doctrine of economic substance by different courts.

One of the most frequently cited contradictions was that some courts examined both the economic substance and the commercial purpose of a transaction in order to determine the economic substance of a particular transaction (the “subjunctive test”), while others held that the presence of an economic substance or commercial object was sufficient to reach a conclusion (the “disjunctive test”). [5] Idat o) 5) C) (“The determination of the relevance of economic substance for a transaction shall be made in the same way as if this paragraph had never been adopted.”). [2] Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed. Cir. 2006) (“The doctrine of economic substance [requires] disregard for transactions that conform to the literal provisions of tax law, but are devoid of economic reality.”). Economic substance exists only if: “(A) the transaction materially changes the taxpayer`s economic position (other than [federal, state, and local] tax effects[6]) and (B) the taxpayer has an important purpose (other than [federal, state, and local] tax effects) in entering into such a transaction.” [7] The evidence for establishing the economic substance of the IRC is similar to that of the case law, and case law should be consulted to analyze whether or not the two points of section 7701(o) are met in a given situation.

[8] Although the doctrine of economic substance has certainly been incorporated into the Internal Revenue Code by section 7701(o) of the I. R.C., it has not been fully codified. This is an evolving concept that makes aggressive tax planning extremely costly within the existing criminal justice system. The likelihood of disclosure of a transaction with no economic substance is likely to be low for taxpayers who are not subject to an audit under the G.A.A.P. of the United States. or subject to auditor analysis in accordance with FIN 48, which addresses uncertain tax situations. Without the insight provided in a U.S. G.A.A.P. audit, taxpayers may not have a transaction reporting and disclosure system. In comparison, if a U.S. G.A.A.P. audit is conducted and a reserve is made in respect of an uncertain tax situation, the UTP Schedule must be attached to the tax return for the year in which the reserve is established, and the taxpayer`s assets exceed the $10 million threshold specified in the instructions.