Side Effect of ACA Repeal Could Include Tax Shelters
- Economic substance doctrine change could make pro-tax shelter argument stronger
- Tax shelter use has been on decline as IRS has gone after “abusive” transactions
The U.S. government would have a tougher time shutting down tax shelters if congressional Republicans
successfully repeal all the tax provisions that fund the Affordable Care Act.
Among better-known revenue-raisers, such as the “Cadillac tax” on high-cost employer-provided plans, the ACA
included a provision known as the “economic substance doctrine” that was designed to make tax collectors’ jobs easier.
That provision allows federal auditors to go after transactions that lack any business purpose
other than generating tax benefits. Now, it may be lumped into an effort to repeal the law—making it much harder for the Internal Revenue Service to rely on the doctrine.
“It would be something that would be very welcome by people who design tax shelters,” said Stuart Bassin, a tax controversy lawyer and former Justice Department tax litigator.
Investments designed to decrease taxes aren’t necessarily illegal. But the IRS has been looking more closely at deals that seem to lack economic rationale other than avoiding federal taxes. Since the early 2000s, the government has been cracking down on the use of tax shelters that had been promoted by large financial institutions, such as KPMG LLP and Barclays Bank Plc.
U.S. courts had used varying interpretations of the economic-substance doctrine for decades—based on case law—before Congress included the provision in the ACA in 2010. An explicit repeal from Congress would make it much harder for the IRS and the courts to rely on it, Bassin told Bloomberg BNA Feb. 28.
On the Offensive
The economic substance test is often central for the IRS to combat tax shelters, though the codified version has yet to play a role in cases currently being litigated because they deal with transactions occurring before the law’s 2010 enactment. The investments typically comply with the letter of the law, but not the spirit.
KPMG and Barclays sold a series of transactions involving trusts and foreign tax credits from 2002 to 2007 that lacked economic substance and were “simply a money machine,” a U.S. Court of Appeals for the Federal Circuit ruled in 2015. The court imposed $112 million in penalties on BB&T Corp. in 2013, but that amount is being reassessed after the appeals court ruled that the bank could deduct some of the interest in connection with the transaction.
The IRS also won tax shelter cases against Bank of New York Mellon Corp. seeking $200 million in credits and American International Group Inc. attempting to claim $48.2 million where judges determined that transactions from the late 1990s and early 2000s lacked economic substance. Both cases were appealed to the U.S. Supreme Court, which declined to hear them. The agency has also settled thousands of tax shelter cases involving partnerships and individuals investors since 2005.
The use of tax shelters has greatly decreased in recent years as IRS officials and stiffer penalties—included in the economic substance doctrine addition to the tax code—have sought to curb tax evasion. Under current law, liability underpayments tied to tax shelters are 40 percent, but that could be reduced to 20 percent if the law is repealed. The law’s removal also eliminates the Treasury Department’s authority to write regulations about what types of tax shelter transactions relate to the economic substance doctrine, said Andy Grewal, a professor at the University of Iowa College of Law specializing in tax and administrative law.
“The penalty does play a role in making taxpayers think twice,” said David P. Hariton, a partner at Sullivan & Cromwell LLP who advises financial institutions. “Taxpayers know if they are more aggressive and they lose, they have a bigger downside.”
Shutting down tax shelters has largely been a bipartisan issue over the years. Former Senate Finance Chairman Max Baucus (D-Mont.) and ranking member Charles E. Grassley (R-Iowa) pushed for it to be included in the 2010 health care law. Grassley’s spokeswoman said the senator would like the doctrine to stay as is, to maintain tax compliance.
The push to curb tax shelter activity stems from a 2003 Senate Permanent Subcommittee on Investigations report that found “major accounting firms, banks, investment advisory firms, and law firms have become major developers and promoters” and that “respected professional firms” spent substantial resources to design hundreds of complex tax shelters.
Ways and Means Chairman Kevin Brady (R-Texas) said Feb. 27 that the leaked draft of the ACA repeal bill, dated Feb. 10, has undergone several revisions. His office declined to comment on the economic substance test repeal in the document. The provision could be removed during the bill-writing process because it will lose revenue, Bassin said.
Popular shelters that the IRS has determined lack economic substance include Son-of-BOSS (bond option sales strategy) transactions designed to reduce federal income tax obligations on capital gains from the sale of a business. Another shelter, Structured Trust Advantaged Repackaged Securities (STARS) deals, include a series of transactions used to generate foreign tax credits and other deductions to reduce tax liabilities.
Tax Shelters on the Rise?
Repealing tax code Section 7701(o), which contains the economic substance test, wouldn’t eliminate the underlying principles, but would leave it up to the judiciary to interpret the “nebulous doctrine where the case law varies by Circuit,” Lawrence Hill, a partner at Winston & Strawn LLP specializing in litigation, told Bloomberg BNA Feb. 28.
The accounting firms, law firms and banks that previously marketed these transactions view economic substance as a big obstruction to reviving transactions that comply with the law but that the government may not like, Bassin said, but they may become more comfortable with some of these deals if the doctrine isn’t as big of a roadblock.
“The institutional promoters of the transactions got scared, so they will be much more conservative in analyzing it next time around,” he said.
But the conditions for a tax shelter uptick could be forming as a series of IRS budget cuts has led to declining numbers of audits and reduced the examination staff by nearly 30 percent since 2010.
“These things are cyclical,” Hill said. “When IRS resources are weak, tax strategies tend to peak.”
A reduction in IRS enforcement, less emphasis on the economic substance doctrine, a lack of regulations and lower penalties could lead to an increase in tax planning that involves shelters.
“There are really smart people out there who can move the boxes and transaction around to comply with the letter of the statute, and what keeps them from selling their creations is the economic substance doctrine,” Bassin said. “You can’t predict what it’s going to do.”