Tax News
NYSBA Issues Report No. 1228 on Codification of the Economic Substance Doctrine
January 07, 2011
I personally find most of the NYSBA reports to be very comprehensive and informative.  This report does not differ in this respect.  The report addresses the codification of economic substance, an issue that has been talked about in length, and rightfully so.  I recently wrote a separate piece on Notice 2010-62, the first eagerly awaited Treasury guidance on the issue.  As I mentioned in that note, economic substance has an universal tax implication that is not limited only to the tax exposure of private equity, venture capital and hedge fund.  As to funds, the report highlights quite nicely one of the most acute issues that could come up in fund operations. Funds sometimes engage in transactions that are arguable when it comes to their federal income tax merrits.  To avoid the 20% penalty under Sec. 6662 of the Code, the funds will either rely on “reasonable cause” or on “adequate disclosure.”  However, newly amended Sec. 6662(b)(6) of the Code provides for a 20% penalty for “[a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.” In turn, Sec. 6662(i)(1) increases this penalty to 40% for any nondisclosed noneconomic substance transactions.  In other words, a fund that does not make a disclosure for a particular transaction could be subject to a 40% penalty if the transaction is cast away based on economic substance doctrine grounds. To top this off, under newly amended Sec. 6664(c)(2) of the Code, the reasonable cause exception does not apply; thus, the fund cannot rely on legal tax opinions to abate the penalty.

The report has several astute observations which Treasury will hopefully heed.  The first one is that Treasury must clarify that economic substance means economic substance.  While this may seem simplistic, it is not unusual that courts confuse various doctrines such as step transaction, substance over form or adequate business purpose.  In other words, the NYSBA points out that it should be plainly clear that the penalties apply only to disallowances under the two-prong conjunctive test and nothing else.  Second, they point out that for penalty purposes, “any similar rule of law” should be clarified and "similar law" should exclude statutory anti-abuse rules such as Sec. 269 and other non-economic substance anti-abuse doctrines. It remains to be seen whether Treasury will accept these comments, but if it does, funds and their investors would clearly benefit from these clarifications.  If no such clarifications are adopted, and a fund engages in an arguable transaction from tax perspective,  it seems that the penalty net would be quite broad and the fund could fall prey to a stunning 40% penalty wrist-slap.    

The report could be downloaded from the NYSBA website at http://www.nysba.org and is also included below.

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Tags: economic substance, economic substance codification, NYSBA