Hastings Business Law Journal


Section 7701(o) of the Internal Revenue Code of 1986 (the “Code”) imports the judicial doctrine of economic substance into statutory language. The economic substance doctrine provides that certain tax benefits can be denied if they go beyond congressional intent, even if all of the literal requirements of the Code and its regulations are met. The doctrine is perpetually controversial and has been the subject of recent litigation. This article argues that codification changed the economic substance doctrine (rather than just copying it into statutory form) and produced unintended consequences, many of which have gone unnoticed. The article analyzes the language and structure of Section 7701(o) in order to explain its legal consequences and its substantive differences from previous case law.

The article argues that Section 7701(o) unintentionally changed the conjunctive test that it was trying to codify. The “conjunctive test” in the economic substance case law requires that a transaction must meet both an objective test (focusing on economic effects) and a subjective test (focusing on the taxpayer’s intent or “business purpose”), not just one or the other. The structure of Section 7701(o), combined with rules of statutory interpretation, shows that these two prongs are now equal to each other, and that their content now cannot be identical. In the pre-codification case law, in contrast, the objective and subjective analyses often duplicated each other because both focused largely on reasonable expectation of profit. When the objective and subjective tests differed from each other, the objective prong was often given greater emphasis. Section 7701(o) appears to have changed all of that for years to which it applies.

This article also explains several other changes that Section 7701(o) made to the economic substance doctrine. Further, this article argues that the delineation of the tested transaction has not been changed by codification—the IRS and the courts have the same ability to define the tested transaction as they did before. This is a crucial issue that can determine the result of an economic substance analysis, causing a tax benefit to be either respected or disallowed.