Economic Substance De-Codification and the Supreme Court
As one of the revenue raisers to offset the costs associated with the Affordable Care Act, Congress added Section 7701(o) to the tax code. That provision, which has nothing to do with health care, codifies the “economic substance doctrine” created by the federal district courts and appellate courts. Generally speaking, under the doctrine, the lower courts apply a two-factor test to determine whether to respect a taxpayer’s compliance with statutory law. Prior to codification, there had been some some disagreement in the lower courts on how to apply the two factors, and the new statute addressed that controversy.
Because of its association with the ACA, Section 7701(o) is now on the chopping block as part of the Republicans’ effort to repeal and replace the entire health care law. See POLITICO, “Tax dodgers could be winners under ACA repeal,” (3/1/17). In a separate post, my co-blogger Daniel Hemel considers the potential effect of Section 7701(o)’s repeal and, in particular, whether its repeal would imply a Congressional rejection of the doctrine itself. He concludes that repeal of Section 7701(o) would likely “restore the status quo ante.” That is, the doctrine will continue to exist even if Section 7701(o) doesn’t, and lower courts should revert to their pre-codification practices regarding the doctrine. Professor Leandra Lederman concludes similarly, using a different path of analysis. I agree with both Daniel and Leandra’s ultimate conclusions here — absent some contrary statutory indication, repeal of Section 7701(o) will return us to pre-2010 law.
On the merits, Daniel and Leandra each express opposition to Section 7701(o)’s repeal, though I would consider it a great blessing. Specifically, repeal of the statute would expedite the Supreme Court’s much-needed review of the economic substance doctrine. Section 7701(o) fiddles with the factors related to the doctrine, but it does nothing to address the most important question — when does the doctrine apply? Section 7701(o)(5)(C) simply directs courts to answer that question “in the same manner as if [the statute] had never been enacted.” That is an exquisitely odd approach for a statute that purportedly offers a “clarification” of existing law.
As I’ve explained at length elsewhere, the Supreme Court has never applied the economic substance doctrine in the way that the majority of lower courts use it, that is, as an extra-statutory hurdle to the claiming of tax benefits. See Grewal, Economic Substance and The Supreme Court, Tax Notes, Vol. 116 (2007). Consequently, Supreme Court guidance is needed to restore clarity and integrity to this area of the law. For further elaboration of this point, see my certiorari-stage amicus brief in WFC Holdings v. United States, downloadable here.
Admittedly, my view reflects a minority position within the tax academy, though the Supreme Court seems much more open minded. In Woods v. United States, I submitted an amicus brief recommending that the Court hold off on expressing an opinion on the validity of an extra-statutory doctrine, which the tax academy considers settled law. The Court accepted that recommendation, stating that it was “express[ing] no view” of the doctrine, citing my brief on a separate point. Thus, the Supreme Court considers the proper application of the economic substance doctrine an open issue. Also, the Sixth Circuit, in Summa Holdings v. IRS, likened the IRS’s application of extra-statutory doctrines to measures undertaken by Caligula, who “posted the tax laws in such fine print and so high that his subjects could not read them.” The use of extra-statutory doctrines in tax thus remains controversial even within some lower courts.
But as long as Section 7701(o) remains on the books, the Court may take its time in addressing the controversy over the economic substance doctrine. Though there are various pending cases involving pre-7701(o) law, the Court may want to wait for a case to arise under the new statute. That could be years from now, given the lengthy progression of complex tax controversies.
However, if Section 7701(o) were repealed, the Court could go ahead and take one of the pending cases. For that reason and many others, I hope that Congress repeals Section 7701(o), so that some sense can be restored to this area of the tax law.