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US Healthcare Bill To Codify Economic Substance Doctrine

by Glen Shapiro,, New York

27 July 2009

The economic substance doctrine used by US courts to determine whether a transaction is structured with the sole intent of avoiding tax will be codified under plans to raise money to pay for President Obama’s healthcare reforms.

The economic substance test is a judicial doctrine that has been used by judges to deny tax shelters when the transaction generating these tax benefits lacks an underlying economic purpose. However, the courts have not applied the doctrine uniformly, and the health reform legislation would clarify the manner in which the principle should be applied by the courts.

According to House Democrats, who drafted the bill, the current-law standards used by courts in determining when to utilize an economic substance analysis will not change.

Under the provision, the economic substance doctrine would be satisfied only if: the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and; the taxpayer has a substantial non-federal tax purpose for entering into such transaction.

The provision also imposes a 20% penalty on understatements attributable to a transaction lacking economic substance. This penalty increases to 40% in the case of transactions in which the relevant facts affecting the tax treatment of the transaction are not adequately disclosed.

It is estimated that codifying the economic substance doctrine would raise USD3.6bn in additional tax revenues over 10 years.

The proposal is one of several revenue-raisers contained in the America’s Affordable Health Choices Act 2009, which was recently passed by the House Ways and Means Committee, clearing the way for a full House vote soon.

The most significant revenue provision is a ‘surtax’ on the incomes of the well-off, starting at 1% for joint filers reporting income in excess of USD350,000 and rising to 5.4% on joint income in excess of USD1m, and which is set to raise USD544bn over ten years.

Other revenue items include: a nine-year delay in the introduction of liberalized worldwide interest allocation rules for the purposes of determining a taxpayers foreign tax credit limitation, which is currently set to be phased in from 2010, raising USD26.1bn over 10 years; and limiting tax treaty benefits for certain deductible corporate payments routed through low-tax jurisdictions, raising USD7.5bn over 10 years.

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