The IRS has contended, and many courts have agreed, that a transaction should be disregarded for federal income tax purposes if it was undertaken to accomplish tax avoidance. Application of this standard has not been uniform. The courts have considered one or more of the following questions—Does the taxpayer have a reason for undertaking the transaction other than tax considerations? Can the taxpayer demonstrate a non-tax “business purpose”? Does the taxpayer have a reasonable prospect of making a “profit” from the transaction?
Whether it was a desire for a uniform standard or merely a way to raise federal revenues, new Section 7701(o), which “codifies” the “economic substance doctrine,” became law in March 2010, as part of the “Health Care and Education Affordability Reconciliation Act of 2010” (the “2010 Reconciliation Act”). The new law is effective for transactions entered into after March 30, 2010, and it provides both a definition of economic substance, and a penalty that may apply if a taxpayer enters into a transaction that fails to have economic substance.
If a tax credit transaction is found to not have “economic substance,” then some or all of the credits and related deductions will be disallowed. In addition, either a 20% penalty will apply if the transaction is disclosed on the taxpayer’s return, or a 40% penalty if it is not. Of course, for disclosed transactions, this is the same rate as the substantial understatement penalty, so the additional cost of the new rules may not actually yield larger penalties.
This brings us to the definitional part of the analysis.
The statutory provision is rather terse. For any transaction to which the economic substance doctrine is relevant, the transaction will be 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. A transaction’s “profit potential” may be taken into account in determining whether a transaction meets this second test, but only if the present value of the expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction was respected. In doing this computation, fees, and other transaction expenses are taken into account as expenses in determining pre-tax-profit.
So, we begin with the question of whether the economic substance doctrine is even “relevant,” and if it is, we next consider whether it results in a “meaningful” change that is “economic,” but not on account of federal income tax. Finally, we consider the taxpayer’s purpose, looking for something “substantial,” other than federal income tax, noting that we may take profit motive into account only if the present value of the pre-tax profit, after taking into account transaction expenses, is substantial when compared to the present value of the anticipated tax benefits. Note the complexity of this last test—if a taxpayer has a substantial motivation that is not related to profit, then the test is passed, but if the motivation is instead based on the pre-tax potential for profit, then that potential must be substantial when compared to the tax benefits, all computed on a present value basis.
This may sound troublesome in many tax credit motivated transactions, i.e., those where the taxpayer takes tax credits into account as part of the anticipated return, with any anticipated cash being small when compared to the credits. For example, imagine a $1 million investment that yields a $1 million tax credit in year one, five years of MACRS depreciation, and a $50,000 cash payment in year 6, when the investor sells his interest and leaves the transaction. Is $50,000, paid six years from now, “substantial” when compared to $1m of tax credits today, plus the value of five years worth of depreciation deductions? Or, suppose a somewhat more cash-driven case in which the taxpayer expects to receive $20,000 in cash for each of the next 20 years, followed by a $200,000 payment in year 21. While $600,000 in payments may be “substantial” in an absolute sense, this declines significantly, to about $195,000 at a 10% discount rate, or $320,000 at a 5% rate. Are these numbers still “substantial” when compared to the tax benefits that have a present value of more than $1,250,000 at either discount rate?
Fortunately, there is a savings feature for tax credit transactions.
The Joint Committee on Taxation prepared the “Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as amended, in combination with the ‘Patient Protection and Affordable Care Act’” (the “Technical Explanation”). It provides that the codification is not intended to change current law standards in determining when to utilize an economic substance analysis, and it 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.
More important to the tax credit community is footnote 344 of the Technical Explanation. It provides an important rule for tax credit transactions:
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.
Accordingly, it appears that transactions that feature the typical tax credits will generally not be subjected to economic substance analysis.
We shouldn’t expect every credit transaction to get a free pass on the economic substance test. Even under the footnote, transactions must be “consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate.” Accordingly, a transaction may still be at risk if it includes additional parties, fees, or arrangements that go beyond the Congressional purpose or plan. Indeed, the Technical Explanation specifically approves of “bifurcating” a transaction to address the disallowance of tax-avoidance objectives that have been combined with non-tax objectives. Furthermore, footnote 344 refers only to “tax credits” not being disallowed; it does not indicate what the treatment should be for related tax items, such as depreciation or interest expense. Finally, transactions involving the recent grant programs, like Section 1602 for housing, and 1603 for renewables, resemble tax credit transactions in many ways, but it’s not clear that they are eligible for the benefits of footnote 344, which refers specifically to credits.
We expect that a typical tax opinion will now feature a discussion of how the particular investment complies with the rules of new Section 7701(o) so as to meet the requirements of “Circular 230.” It should be noted that some tax advisors have expressed concern about relying on a footnote in a “technical explanation” produced by the Joint Tax Committee in writing a tax opinion. However, this seems unlikely to be a problem; both case law and Treasury regulations give substantial deference to Joint Tax Committee explanations.
Relying on the footnote, and noting that the project has (i) produced units of affordable housing in compliance with a “qualified allocation plan” in the case of housing projects, (ii) rehabilitated an historic structure in compliance with the rules of local historic preservation offices and the United States Parks Service in the case of historic projects, (iii) developed a project in a poor community that (typically) employs low-income persons in compliance with the rules of the CDFI Fund and the award of new markets tax credits to the CDE in the case of new markets tax credit projects, or (iv) established and operated a renewable energy facility to save energy resources in compliance with the congressional objective to reduce America’s reliance on conventional fuels, it shouldn’t be hard to demonstrate consistency with a congressional purpose or plan. Of course, energy credit transactions do not have a third party or governmental approval process like the others, but it should nonetheless be possible to cite to the anticipated benefits of the energy tax credit that encourages the construction and operation of renewable energy facilities.
Still, it is important to scrutinize the actual business deal, which is where we will compare the economic and tax benefits. For example, notwithstanding footnote 344, should a transaction with unreasonable fees still be respected as having “economic substance”? And, as noted above, adding additional “features” to a transaction may ultimately “distort the liability of the particular taxpayer.” So, be sure to have any credit transaction reviewed by your professional tax advisor.
Finally, are the cash distributions associated with historic and some renewable transactions now superfluous in view of the congressional purpose or plan of rehabilitating historic structures or generating renewable energy? As of now, tax advisors are treating the economic substance rules as an additional test, and not something that might lessen the standards that applied before the test became law. Of course, this may change.