Repealing Economic Substance Codification and Replacing It With What?
The Republican effort to repeal the Affordable Care Act appears to be stalling. If and when it picks up again, the fate of section 7701(o) of the Internal Revenue Code will be far from the most consequential issue at stake. But section 7701(o), the provision added by the ACA that codifies the tax law economic substance doctrine, matters still — to the tune of $5.8 billion in federal revenue that will be lost over the next decade if the provision is repealed. Or so the Congressional Budget Office estimates; what repeal of section 7701(o) would actually accomplish is something of a mystery. [See Leandra Lederman’s cross-linked post at Surly Subgroup for more on what repeal of section 7701(o) might mean for common law tax anti-abuse doctrines, and for Leandra’s characteristically thoughtful take on the policy implications of repeal.]
By most accounts, the common law economic substance doctrine dates back to the 1935 Supreme Court case Gregory v. Helvering. (For a comprehensive account of the doctrine’s evolution through 2010, see Leandra Lederman, W(h)ither Economic Substance, 95 Iowa L. Rev. 389 (2010).) By 2010, the doctrine was widely understood to incorporate an objective prong and a subjective prong: (1) objectively, did the transaction have economic substance?; and (2) subjectively, did the taxpayer have a business purpose for entering into the transaction? Yet courts applied the two prongs inconsistently: some courts would recognize a transaction only if it satisfied both prongs; others said that satisfying either prong was enough; and still others focused exclusively on one of the prongs or applied something like a balancing test.
As part of the ACA, Congress added a provision to the Code clarifying the economic substance doctrine’s contours. That provision, section 7701(o), begins:
In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—
(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
Section 7701(o) leaves no doubt as to whether the test is conjunctive or disjunctive: a transaction must have both objective economic substance and a subjective business purpose in order to pass the test. Congress also included (as part of the ACA) a 20% underpayment penalty for transactions lacking economic substance, increasing to 40% for taxpayers who fail to disclose such transactions with their returns.
Fast forward to 2015, when Representative Tom Price (R-Ga.), soon to be President Trump’s Secretary of Health and Human Services, introduces legislation to repeal parts of the ACA via the budget reconciliation process. Everyone knew at the time that the repeal legislation would be vetoed by President Obama (as indeed it was), but the bill was considered a “dry run” in the event that a Republican won the White House the following November (as indeed one did). The Price bill included a provision that repealed section 7701(o) as well as the penalties for underpayments and nondisclosed transactions. Price did not explain why he wanted to gut the economic substance doctrine codification along with the rest of the ACA. His section-by-section summary accompanying the bill simply said: “Obamacare codified economic substance doctrine, which was a judicial doctrine courts had used to deny tax benefits when the transaction lacked economic substance.” (Perhaps guilt-by-association with Obamacare was guilt enough.)
And here’s where things get tricky: The Price bill also did not say what would happen to the old common law economic substance doctrine after repeal. The penalty provisions would of course be wiped away, but what of the economic substance doctrine itself?
One can imagine (at least) three possible interpretations:
— (1) Repeal of section 7701(o) simply restores the status quo ante. Circuits should revert to their pre-2010 precedent regarding the application of the doctrine’s two prongs.
— (2) Everyone knows that section 7701(o) was intended to make the two-prong test a conjunctive one (i.e., the transaction must have economic substance and business purpose). Congress would have repealed section 7701(o) only if it did not want the test to be conjunctive. So circuits that applied the test conjunctively pre-2010 should apply it disjunctively now (i.e., the transaction need have only economic substance or business purpose).
— (3) If Congress had wanted to convert the conjunctive test into a disjunctive test, it would have simply switched the “and” to an “or.” Congress must have repealed section 7701(o) because it wanted to do away with the economic substance doctrine entirely.
My own view is that the first interpretation is the best one. A “cardinal rule” of statutory interpretation is that “repeals by implication are not favored.” Posadas v. Nat’l City Bank, 296 U.S. 497, 503 (1936). To be sure, that cardinal rule is usually invoked to decide whether a statute enacted at time 2 impliedly repeals a statute enacted at time 1. Here, there is no doubt that the Price bill would repeal section 7701(o); the question is whether a statute enacted at time 2 that explicitly repeals a statute enacted at time 1 also impliedly repeals a common law doctrine dating to time 0 that was codified at time 1. And yet perhaps we can infer from the Posadas rule a general policy against inferring that an earlier rule has been repealed. If Congress wants to repeal the common law doctrine as well as the codifying statute, it should say so.
We might also look to the principle that “statutes which invade the common law . . . are to be read with a presumption favoring the retention of long-established and familiar principles, except when a statutory purpose to the contrary is evident.” Isbrandtsen Co. v. Johnson, 343 U.S. 779, 783 (1952). Again, one might question whether that principle applies to “common law” tax doctrines such as economic substance. But I think that the two principles above — (1) that repeals by implication are disfavored; and (2) that statutes in derogation of the common law should be construed narrowly — are about as close as a fit for the section 7701(o) scenario as we can find (even if neither fits perfectly).
Moreover, we can imagine reasons why Congress might have wanted to repeal section 7701(o) and not codify a disjunctive test or eliminate the economic substance doctrine entirely. Perhaps repeal is an invitation to circuit court experimentalism. Members of Congress might have thought: “We’re not quite sure what the optimal version of the economic substance doctrine looks like, so let’s let the circuit courts tinker a little bit longer until a clear first-best version emerges.” Granted, it’s more likely that members of Congress who voted in favor of the Price bill didn’t give much thought to the economic substance doctrine at all. And yet the experimentalism possibility is probably enough to show that there was no “evident” statutory purpose to switch to the disjunctive test or do away with the doctrine. Cf. Isbrandtsen Co. 343 U.S. at 783.
All of this is perhaps best read as a plea to Republicans in Congress: If and when you do return to repeal of the ACA (and, personally, I would be happy if you never return to the task), please think for more than a moment about whether you really want to gut section 7701(o). Consider the fact that one of your own, Senator Chuck Grassley of Iowa, was a leading proponent of economic substance codification long before the ACA was even on the table. This provision has little to do with the health care law you detest. And at the very least, please make clear that repeal of section 7701(o) wouldn’t alter the law in circuits that had adopted a conjunctive test already, and that it wouldn’t eviscerate the doctrine entirely. ACA repeal might cause millions to lose their health insurance, but there is no reason why we should lose billions to tax avoidance at the same time.