Tax Analysts Blog

Economic Substance Doctrine Escapes ACA Repeal

Posted on Mar 8, 2017

The Republican alternative to Obamacare is finally here. House Republicans released their plan to repeal and replace the Affordable Care Act, dubbing it the American Health Care Act (AHA). While not quite Obamacare lite, the AHA retains several aspects of the ACA, including two that were widely expected to be repealed: the tax on so-called Cadillac insurance plans and the codification of the economic substance doctrine. The latter was the subject of a recent misinformation campaign by opponents of repeal.

The economic substance doctrine gained notoriety during the early 2000s as the Justice Department and IRS took aim at various tax shelter strategies. The doctrine was frequently used by courts to look through the form of transactions such as son-of-BOSS arrangements to find the true substance of the deal, and to assess higher taxes. Courts became quite adept at employing the economic substance doctrine to disregard a variety of tax planning techniques, putting an end to the last wave of shelter transactions. A few commentators argued that courts were too quick to use the economic substance doctrine, invalidating some techniques that could have been attacked on statutory grounds. 

However, some in Congress didn't think courts were going far enough. After some high-profile taxpayer wins when several courts refused to use the judicial economic substance doctrine, a measure began floating around that would codify it, transforming it into a statutory doctrine that courts would be required to employ. Proposals to codify the doctrine were first introduced in 1999, but the measure didn't really pick up steam until the last years of the George W. Bush administration and the first years of President Obama.

While a desire to help shut down tax shelters and bring recalcitrant pro-taxpayer courts into line might have been a factor in the push to codify the economic substance doctrine, the real reason for the measure's growing popularity in 2009 and 2010 was that the Joint Committee on Taxation gave the measure a rather high revenue score. Initially, the JCT said codification would raise $17 billion over 10 years, a rather hefty score for something so minor. Later versions of the codification proposal would score lower, and by 2010 the JCT said that it would raise only $4.5 billion (this was also partly because of courts' increasing willingness to employ the doctrine without the aid of a statute). Still, the measure had attracted the attention of Democrats, who were scrambling for anything they could find to pay for the ACA.

And so section 7701(o)(1) became a part of the code after the passage of the Health Care and Education Reconciliation Act of 2010. Codification was never all that popular with the tax bar or even with the judiciary. Many thought it was an overreaction to a few prominent taxpayer wins in shelter cases that became less important as the government piled up victory after victory and basically ended the viability of most shelter transactions being used in the 1990s and early 2000s. Others thought it was unnecessary and doubted it would raise any significant revenues. And some simply thought that it encouraged courts to disregard the law in tax cases in favor of subjective standards of whether a transaction "felt" like a tax dodge. It's hard to say whether codification has had much effect given that tax shelters were already in sharp decline by the time section 7701(o)(1) came into effect.

 But that didn't stop ACA fans from raising a small furor when Republicans revealed that the provision wouldn't survive a possible repeal of Obamacare. The Center on Budget and Policy Priorities issued a release saying that repeal would embolden tax evaders. This made its way into the mainstream media, which spun it into the fact that Republicans were trying to make it easier for companies to engage in tax avoidance -- never mind that the economic substance doctrine was in widespread use by courts before section 7701(o)(1).

Those stories (and possibly the small revenue score) had an effect. The complete non-crisis has been averted by the fact that economic substance codification will not be repealed if the AHA is passed by Congress. Codification is just a lesson in how even the smallest, most insignificant provisions can become ammunition in the hyperpartisan climate in Washington.

Read Comments (1)

Mike55Mar 8, 2017

"Codification is just a lesson in how even the smallest, most insignificant provisions can become ammunition in the hyperpartisan climate in Washington."

You are 100% correct: in actual real-world tax practice, 7701(o) is pretty much irrelevant. Practitioners (myself included) did an awful lot of handwringing when 7701(o) was first enacted but, after a couple years, everyone figured out it's really just a new penalty provision. When you perform a careful parsing of the statutory language and compare it to the pre-existing law, nothing has actually changed (aside from the penalties).

This is not to make light of a 40% strict liability penalty (i.e., what 7701(o) actually did) by any means. However the reality for most practitioners, at least in my area, is that penalties simply don't effect go/no-go tax planning decisions. You'd never do the underlying transaction in the first place if you thought there was a significant risk it'd fail to pass IRS muster, so adding the 40% penalty doesn't really move the needle.

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