The Codification of the Economic Substance Doctrine

Transcription

1 Colorado Bar Association Tax Section The Codification of the Economic Substance Doctrine October 13, 2010 David Strong Managing Partner Tax Practice Group 1700 Lincoln Street; Suite 4100 Denver, CO Phone: (303) Denver Boulder Colorado Springs Dublin London Los Angeles Munich Phoenix Salt Lake City San Francisco

2 Professional Biography David Strong Managing Partner Tax Practice Group Holme Roberts & Owen LLP 1700 Lincoln Street; Suite 4100 Denver, CO Phone: (303) Practice Experience David B. Strong ( Dave ) is a partner in HRO s Denver office and currently serves as the Managing Partner of HRO s Tax Practice Group. Dave advises clients on the tax aspects of a wide variety of transactions including mergers and acquisitions, joint ventures / partnerships, restructurings, and private equity and venture capital investments. Dave also advises clients with respect to federal, state, and local tax examinations and related tax controversy matters. Dave is an active member of the Corporate Tax Committee of the Tax Section of the American Bar Association and a frequent speaker on corporate tax matters at local, regional, and national seminars and continuing legal education programs. Prior to joining the firm, Dave practiced as a tax attorney in New York City with Shearman & Sterling and Covington & Burling and also worked for Deutsche Bank as an investment banking professional in its mergers and acquisitions group.

3 Professional Biography (cont d) Representative Transactions Selected Mergers & Acquisitions: Examples of merger and acquisition transactions on which Dave has provided tax advice include: $11.0 billion tax-free merger of equals transaction $4.0 billion stock-for-stock tender offer for publicly traded software company and subsequent squeeze-out merger $3.2 billion tax-free merger involving the combination of both domestic and international manufacturing operations $2.1 billion tax-free merger between two domestic oil exploration and production companies $1.5 billion stock-for-stock tender offer for outstanding minority public stake and subsequent squeeze-out merger $280 million foreign stock purchase transaction $100 million disposition of controlling voting stake in publicly-traded company Purchase of professional sports franchise Selected Capital Markets Transactions: Examples of capital market transactions on which Dave has provided tax advice include: $850 million common stock offering utilizing a hybrid corporate/partnership Up-REIT structure $1.0 billion convertible note offering utilizing call-spread hedging structure $1.0 billion stock rights offering 500 million convertible note offering $500 million pay-in-kind convertible note offering $300 million bond repurchase $1.0 billion issuance of dividend-paying stock by publicly-traded foreign corporation to U.S. Holders Variable pre-paid forward contract monetization strategy for concentrated position in publicly-traded stock

4 Professional Biography (cont d) Education LL.M. (Masters in Taxation), New York University School of Law J.D., Stanford Law School B.S.B.A. in Economics, University of Denver, magna cum laude Accomplishments/Affiliations Former President, Denver Chapter, Association for Corporate Growth Recipient, Tax Section, American Bar Association, John S. Nolan Fellowship Officer, Corporate Tax Committee, Tax Section, American Bar Association Member, Denver Business Forum Member, Denver Metro Chamber 100 Member, New York Legal Aid Society Member, Stanford Law School Alumni Association Graduate Editor, Tax Law Review Associate Editor, Stanford Law Review Editor, Stanford Law and Policy Review Licensed Colorado New York Minnesota Bar Associations American Bar Association (Tax Section) Colorado State Bar Association (Tax Section) New York State Bar Association (Tax Section)

5 Agenda Executive Summary General Background The Statute & Legislative History Interim Guidance Critical Issues Affecting Implementation ABA Tax Section / AICPA White Paper Developing a Practical Approach

6 Executive Summary New 7701(o) and its related penalty provision contained in 6662(b)(6) were enacted as part of the Health Care and Education Reconciliation Act of 2010 (P.L , 124 Stat. 1029) (March 30, 2010) The legislation effectively codifies the judicial economic substance doctrine ( ESD ) and imposes a strict liability penalty of 20%, which increases to 40% if the disallowed benefits were not adequately disclosed Many aspects of the legislation are the subject of significant ambiguity and uncertainty, and it remains to be seen how the IRS will apply the provisions in practice (and in light of a high revenue mark in the President s budget) In particular, IRS and Treasury have stated that they have no intention to issue general administrative guidance regarding the application of the ESD (no angel list or demon list ) and there is no intention to issue PLRs As a result, and especially in light of the potential strict liability penalty, taxpayers and their advisors must consider the ESD carefully and be prepared to explain its application in the context of all transactions that may be evaluated for FIN 48 purposes, for purposes of uncertain tax position disclosure, or on exam

7 General Background Development of the ESD by the courts Over the past 75 years (tracing back to 1935 U.S. Supreme Court case of Gregory v. Helvering) the courts developed the ESD to backstop the literal provisions of the Code The conjunctive test (both economic substance and business purpose) The disjunctive test (either economic substance or business purpose) The facts and circumstances test (factors in an overall evaluation) Reasoning of cases is often hard to follow; specific facts are critical Some cases find the ESD not relevant or effectively not applicable (e.g., Cottage Savings and Sacks) History of the codification effort Traces back to February 1999 proposed expansion of 269 Designed to prevent ad hoc enforcement and to clarify judicial standards Tension between codification and deference to the courts Final passage in March 2010 high revenue mark attached to ESD Experience in other contexts California s NEST penalty Codified GAARs in Australia, Canada, Germany, and New Zealand Anti-abuse regulations (e.g., Treas. Reg )

8 The Statute The new statute effectively codifies a conjunctive test in 7701(o)(1): [i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction The statute goes on to provide that [t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if the doctrine had never been codified ( 7701(o)(5)(C)) State and local income tax effects related to a Federal income tax effect shall be disregarded in determining whether a transaction changes a taxpayer s economic position in a meaningful way ( 7701(o)(3))

9 The Statute Any financial accounting benefit generated by a reduction in Federal income tax shall be disregarded in determining whether a taxpayer has a substantial purpose for entering into such transaction ( 7701(o)(4)) Special rule for profit potential as a substantial purpose for entering into a transaction: Only taken into account if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction was respected ( 7701(o)(2)(A)) For purposes of calculating pre-tax profit, fees and other transaction expenses shall be deducted ( 7701(o)(2)(B)) A strict liability, accuracy-related penalty of 20% applies to any disallowed benefits related to a transaction lacking economic substance or failing to meet the requirements of any similar rule of law Strict liability penalty increases to 40% if the disallowed benefits were not adequately disclosed in the return or in a statement attached to the return

10 Legislative History There is no official legislative history to the tax provisions of the Health Care and Education Reconciliation act of 2010 however, useful guidance is available from several sources Various committee reports from the Senate Finance Committee and the House Committee on Ways & Means, as well as technical explanations issued by the Joint Committee on Taxation, were issued in connection with the legislative proposals over the last decade The report issued by the House Committee on Ways & Means on October 15, 2009 in connection with its approval of H.R. 3200, represents the most recent statement of that Committee s motivations behind the ESD However, because H.R was not ultimately enacted (and because the final ESD legislation contained several material differences) the report cannot be considered official (final bill was H.R. 4872)

11 Legislative History In addition to the October 15, 2009 House Committee on Ways & Means report, the Joint Committee on Taxation prepared a technical explanation of the tax provisions contained in the 2010 Act (see JCX March 21, 2010) This technical explanation is probably the closest thing to any official legislative history and although it was never formally approved by either tax-writing committee, it contains contemporaneous analysis of the tax provisions contained in the 2010 Act Importantly, the technical explanation states 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. The technical explanation goes on to provide that the codified ESD is not intended to alter the tax treatment of certain basic 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.

12 Legislative History The technical explanation gives four examples of such meaningful economic alternatives: Capitalizing a business with debt or equity Utilizing a foreign corporation or a domestic corporation to make a foreign investment Engaging in a series of transactions designed to constitute a corporate organization or reorganization under Subchapter C Utilizing a related party in a transaction that otherwise meets the requirements of 482 Finally, the technical explanation indicates that the imposition of the strict liability penalty for failing to satisfy the requirements of any similar rule of law is intended to apply where factors and analyses that are similar to the ESD are utilized, but a different term is used to describe the doctrine (e.g., possibly a substantive sham analysis)

13 Interim Guidance On September 13, 2010, Treasury and the IRS announced interim guidance in Notice regarding the codified ESD and related penalty amendments Such interim guidance generally provides that the IRS will apply the statute as written by Congress (e.g., it will apply the conjunctive test), but that in doing so the IRS will rely on relevant case law under the common-law ESD However, the Notice does not specify which cases will be relied upon, and the notice made clear that Treasury 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 The Notice also indicates that that the IRS will not issue PLRs regarding whether the ESD is relevant to any transaction, or whether any transaction complies with the requirements of Section 7701(o)

14 Interim Guidance With respect to the disclosure requirements, Notice provides that such requirements will generally be satisfied if a taxpayer discloses on a timely filed original return or qualified amended return (on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance) In addition, disclosures made consistent with the terms of Rev. Proc (applicable to large corporate taxpayers under constant exam) will be taken into account In the case of reportable transactions found lacking in economic substance, the disclosure requirements of Section 6011 must also be satisfied Finally, on September 14, 2010, the Commissioner of the LMSB issued a field directive to ensure consistent administration of the strict liability penalty and indicated that any proposal to impose the penalty must be reviewed and approved by the appropriate Director of Field Operations

15 Critical Issues Affecting Implementation When is the ESD relevant? (threshold question under 7701(o)(1)) ABA / AICPA White Paper recommends a 2-part test: (1) Is the asserted benefit clearly consistent with Congressional intent? JCT technical explanation cites several tax credit provisions as examples low income housing credit under 42 renewable energy production credit under 45 new markets tax credit under 45D rehabilitation tax credit under 47 renewable energy facility credit under 38 Consider other tax credits, deductions, non-recognition provisions and elections Also recognize that not all transactions may fall squarely within Congressional intent (e.g., tax credit partnerships where beneficiary of the credit does not assume the investment risk) (2) Non-exclusive list of factors to be considered: Is the transaction a basic business transaction? Recall the 4 transactions identified in the JCT technical explanation include: (i) debt v. equity (ii) foreign or domestic entity (iii) organizations or reorganizations under Subchapter C, and (iv) related party transactions satisfying 482

16 Critical Issues Affecting Implementation Other factors to potentially consider in the context of relevance, include: (1) Whether a stand-alone anti-abuse rule may apply (2) Whether judicial or administrative precedent affirmatively considers and rejects application of the ESD in the context of a substantially similar transaction (3) Whether the transaction involves a corporate reorganization provision that historically has been examined under the business purpose doctrine alone, rather than under a conjunctive business purpose / economic substance test (4) Whether the transaction involves a tax-indifferent counter party (5) Whether the transaction results in significant (e.g., greater than $10 million in any tax year) differences in treatment for tax and financial reporting purposes (6) Whether the transaction results in the separation of income from a related deduction (7) Whether there are significant fees paid to parties that appear to serve as promoters or fees that are contingent on tax benefits or conditions of tax confidentiality are present (8) Whether the taxpayer booked a FIN 48 reserve or made a UTP disclosure (9) Whether the taxpayer has a history of engaging in similar transactions (10) Whether the asserted non-tax benefit relates to the taxpayer s business operations (11) Whether the Federal tax savings are greater than $10 million on a NPV basis (12) Whether the taxpayer has taken steps that minimize the risk of economic loss

17 Critical Issues Affecting Implementation What constitutes the transaction? ( 7701(o)(5)(D) states that the term transaction includes a series of transactions) ABA / AICPA White Paper create a presumption that term will be defined broadly to include all factual elements relevant to a course of action (e.g., sale of property at a loss must account for original acquisition) What does it mean to say that the taxpayer s economic position has changed in a meaningful way aside from Federal income tax effects? ( 7701(o)(1)(A)) ABA / AICPA White Paper more than de minimis; should account for more than income statement and balance sheet items When does a taxpayer have a substantial purpose aside from Federal income tax benefits? ( 7701(o)(1)(B)) ABA / AICPA White Paper more than de minimis; need not exceed tax benefits i.e., need not be the principal or leading purpose When are state and local tax effects sufficiently related to Federal tax effects such that state tax planning cannot constitute a substantial purpose? ( 7701(o)(3))

18 Critical Issues Affecting Implementation How should profit potential be measured? ( 7701(o)(2)(A)) Potential for profit is only taken into account if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction was respected: What is pre-tax profit? (gross income reduced by allocable fees, expenses) When is pre-tax profit reasonably expected? (taxpayer s reasonable belief) What discount rate should be used? (facts and circumstances; valuation concepts) What does substantial mean? (Notice 98-5? ratio of 4 to 1 or 80% to 20%) What is any similar rule of law for purposes of the penalty provisions? ( 6662(b)(6)) ABA / AICPA White Paper does not include isolated business purpose inquiries or substance over form or step-transaction doctrines Disclosure considerations Application of penalties

19 Developing a Practical Approach (1) Is the ESD relevant (2) If the ESD is relevant (or possibly relevant), inquire into: (a) economic substance has taxpayer s economic position been changed in a meaningful way aside from the tax effects perhaps start with the baseline concept of risk (b) business purpose did the taxpayer have a substantial purpose aside from the tax effects perhaps start with the baseline concept of pre-tax profit Define transaction broadly but also consider separate steps Consider relevant Code provisions, regulations, legislative history, and judicial and administrative precedent

20 Developing a Practical Approach Hypothetical Example Busted Type B Reorganization to Generate a Capital Loss: Assume the following facts: Taxpayer ( T ) holds 100% of stock of X with fmv of $200 and historic tax basis of $1,000 X wants to acquire 100% of stock of Y with fmv of $200 in all stock deal T wants to trigger the built-in capital loss in X stock so as to offset with other capital gains Parties structure transaction as a busted B reorganization whereby Y issues voting stock to T along with $1 of cash ESD Issue?

21 Developing a Practical Approach Building on the previous example, what if: X and Y were worth only $50 each? X was worth $200, but Y was worth only $20? X was originally going to acquire Y, but the deal was restructured after T discussed the loss with T s tax advisors? X did little or no diligence into the operations of Y and Y is relatively small in comparison to X? Post share exchange, Y redeems Ysh for cash? X receives convertible preferred stock in Y that has a preference that is effectively pegged to the value of the X business?