The Status of Judicial Anti-Abuse Doctrines if Code Section 7701(o) Were Repealed

As Daniel Hemel points out in a cross-linked post on Whatever Source Derived, if Congress repeals the Affordable Care Act (ACA), it is possible that Code section 7701(o) will go with it. (Section 7701(o) and its accompanying penalty were included in the ACA as a revenue raiser.) This raises the question of what repeal would mean for the economic substance doctrine specifically and for judicial anti-abuse rules more generally. This post makes three main points:

1. Repeal of Code section 7701(o) is not a good idea. At a minimum, its potential repeal should be considered separately from the ACA, as it has no substantive link to the ACA.

2. Repeal of the codified economic substance doctrine should not affect other judicial doctrines.

3. Repeal of Code section 7701(o) would not eliminate the judicially developed economic substance doctrine. Daniel has provided a couple of arguments in support of that view, drawing on statutory-interpretation principles, and I add an argument based on the language of section 7701(o) itself.

First, anti-abuse rules are valuable. They help prevent taxpayers from engaging in artificial transactions designed to produce artificial tax benefits, such as non-economic losses used to offset unrelated income. Some of these transactions may not actually “work” under the technical provisions of the Code, Treasury regulations, or IRS guidance. However, abusive tax shelters typically are structured to take advantage of the literal language of the tax laws. If (and, ideally, only if) technical challenges fail, anti-abuse doctrines help prevent misuse of the tax laws.

I argued in 2010, just before section 7701(o) was enacted, that the two prongs of the economic substance doctrine—business purpose and economic substance—were misdirected and easily avoided, so the doctrine should instead focus on whether Congress had intended the tax benefit the taxpayer claimed. I continue to believe that would be the superior approach. However, having the economic substance doctrine available to the government as a tool is much better than having neither it nor a better replacement. In addition, codification helped in a couple of ways. First, where it applies, it eliminates the textualist argument that the doctrine shouldn’t apply because it isn’t statutory. Second, codification resolved judicial disagreement by providing a conjunctive test for the doctrine’s two prongs. Designing a tax shelter to avoid the application of two prongs is harder than designing it to evade just one. Repeal would thus be a setback in the war against tax abuse.

The codified doctrine is effective for transactions entered into after March 30, 2010. As a result, the cases that mention Code section 7701(o) generally point out that the codified version of the doctrine is inapplicable due to its effective date. That is not to say that the doctrine has had no impact, however. For one thing, it is hard to know how many abusive transactions have been deterred by the codified doctrine. In addition, courts may also cite it in support of their common-law-based analysis. For example, in Santander Holdings USA, Inc. v. U.S., 844 F.3d 15 (1st Cir. 2016), the court stated:

“The statutory test was not made retroactive. Our analysis, however, is not in conflict with that test, as Congress specified that the 2010 codification would be applied as courts have previously and consistently applied the economic substance doctrine. If the codification reveals anything about congressional intent as to pre-2010 STARS transactions, it supports our conclusion.”

Id.at 21 n.9 (citation omitted).

Second, assuming that Congress repeals Code section 7701(o), that certainly should not affect judicial doctrines that weren’t codified. As an extreme example, section 7701(o) did not purport to codify the assignment-of-income doctrine, so repeal should not affect that doctrine. Similarly, repealing section 7701(o) should not affect the step-transaction doctrine, which is a doctrine that focuses on where a “transaction” begins and ends, sometimes collapsing steps that purport to be separate for purposes of determining tax consequences into one larger transaction. Cf. William Joel Kolarik II & Steven Nicholas John Wlodychak, The Economic Substance Doctrine in Federal and State Taxation, 67 Tax Law. 715, 762 (2014) (“The step transaction doctrine differs from . . . . the economic substance doctrine because the step transaction doctrine, operating alone, does not strip the tax benefits from a transaction. Rather, the step transaction doctrine serves to define the parameters of a transaction.”).

If section 7701 were to be repealed, that also should not affect substance-over-form analysis, which rests on the venerable principle that the substance of a transaction should triumph over its form. Although the various doctrines evolved simultaneously and can be difficult for courts to distinguish among, they are distinct. See id. at 760–61 (describing each doctrine). The Kolarik & Wlodychak article explains, in part:

“The substance over form doctrine differs from the economic substance doctrine because it recharacterizes a transaction and then applies the Code to determine the tax consequences of the recharacterized transaction. For example, the substance over form doctrine might operate to recharacterize a lease as a sale. In that case, the tax consequences for the lease would then be determined based on the sale provisions of the Code. In contrast, the economic substance doctrine would continue to characterize the transaction as a lease but would refuse to apply the tax consequences in the Code associated with a lease.”

Id. at 762.

Thus, the substance-over-form doctrine has a life independent from that of the economic substance doctrine. See also, e.g., Altria Group Inc. v. U.S., 658 F.3d 276, 291 (2nd Cir. 2011) (“The substance over form doctrine and the economic substance doctrine are independent bases to deny a claimed tax deduction.”); Weintraut v. Comm’r, T.C. Memo. 2016-142 (“We consider each of the Federal substance over form doctrine, the Federal economic substance doctrine, and the Federal sham transaction doctrine, although closely related and overlapping doctrines in Federal tax law, to be an independent or alternative basis under which we shall reach our ultimate findings . . . .”). That is not to say that courts always maintain crystal clear distinctions among the doctrines. For example, the Tax Court noted in CNT Investors, LLC v. Comm’r, 144 T.C. 161, 193 (2014), “The doctrines’ substantive similarities would not, alone, generate uncertainty for taxpayers (or tenure opportunities for tax academics) if courts applying the doctrines did so using consistent terminology. We have not.”

Courts therefore have to be careful to distinguish among these doctrines. Nonetheless, they are not the same doctrine. Accordingly, (hypothetical) repeal of section 7701(o) should not affect the application of substance-over-form principles. In fact, when section 7701(o) was enacted, the Joint Committee on Taxation stated on page 155 of the Technical Explanation of the Revenue Provisions of the “Reconciliaton Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act”: “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.”

Third, if Code section 7701(o) were repealed, that should not eliminate the judicially developed economic substance doctrine. In his cross-linked post on Whatever Source Derived, Daniel Hemel has provided a couple of arguments supporting that view. I agree with Daniel’s result, but I would start with the text of section 7701(o) itself. The statue reads, in part, as follows:

“(o) Clarification of economic substance doctrine

(1) Application of doctrine In 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. . . .

(5) Definitions and special rules For purposes of this subsection—

(A) Economic substance doctrine

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. . . .

(C) Determination of application of doctrine not affected

The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted. . . .”

I.R.C. § 7701(o) (emphasis added).

First, the heading of the codified subsection uses the word “clarification,” suggesting that the statute is meant to clarify, rather than replace, the then-existing doctrine. This indication is supported by the statutory language, which refers in section 7701(o)(1) to a “transaction to which the economic substance doctrine is relevant,” with an accompanying definition in paragraph (5) referring to “the common law doctrine.” Moreover, section 7701(o)(5) states that “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.” This approach was intentional; the Joint Committee’s Bluebook states (on page 152), “the provision does not change present law standards in determining when to utilize an economic substance analysis.” (The Joint Committee also stated, on page 155, “No inference is intended as to the proper application of the economic substance doctrine under present law.”)

Thus, in section 7701(o), Congress instructed everyone to look to the judicial doctrine (as if the statute never existed), to determine if the judicial doctrine is relevant to a particular transaction. If it is relevant under that case law, then the statute applies to provide various things, such as the conjunctive test stated in section 7701(o) and some additional clarifying rules I omitted from the quotation, such as how profit potential is determined and how transaction fees are to be treated. As Marty McMahon phrased it in Living With The Codified Economic Substance Doctrine, 128 Tax Notes 731 (2010), “The statutory provision merely provides a gloss on the judicial doctrine. It does not supplant the judicial doctrine.”

In sum, it would be best for Congress not to repeal Code section 7701(o). But, if it did, although that statutory gloss on the economic substance doctrine would be gone, the judicial doctrine itself would not cease to exist. Nor would repeal of section 7701(o) affect other judicial anti-abuse rules.