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The Health Care and Education Affordability Reconciliation Act of 2010 (H.R. 4872), signed into law by President Barack Obama on March 30, 2010, includes several tax increases, including the codification of the “economic substance doctrine,” and a tax on certain high-income taxpayers under the Unearned Income Medicare Contribution provisions.

The economic substance doctrine, which has been part of the Obama Administration’s package of tax reform measures for over a year, may deny taxpayers federal tax benefits and may also penalize taxpayers for entering into certain transactions that lack “economic substance” or a business purpose.

The Unearned Income Medicare Contribution imposes a 3.8 percent tax on individual taxpayers who have a modified adjusted gross income (defined below) in excess of $250,000. Also, several other key tax increases are noted below.

Codification of the Economic Substance Doctrine

Effective Date

The Economic Substance Doctrine (the Doctrine) provision applies to transactions entered into after the date of enactment (March 30, 2010). Accordingly, all taxpayers planning transactions involving beneficial tax effects should review the impact of these rules on those activities.

Two-Prong Conjunctive Test

The Doctrine is a common law doctrine that courts have utilized to deny tax benefits arising from transactions that do not result in a meaningful change to the taxpayer’s economic position, even though the transaction may comply with the literal requirement of the Internal Revenue Code (the Code). The Joint Committee on Taxation has indicated that courts have applied this Doctrine inconsistently, noting that some circuits require a valid transaction to have both an economic purpose and a business purpose, while others require that the transaction have either one or the other.

The new provision, Section 7701(o) of the Code, mandates a two-prong conjunctive test that determines whether a transaction has economic substance. A transaction will now have economic substance only “if (1) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”

Transactions Subject to the Economic Substance Doctrine

The new provisions shall be applied to transactions “to which the economic substance doctrine is relevant.” “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.” Therefore, courts should continue to apply present common law standards to determine whether the Doctrine should be applied to a transaction.

According to the Joint Committee, the provision is not intended to alter the tax treatment of certain basic business transactions where the choice between alternatives provides comparative tax advantages, such as “(1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied.”

Additionally, the provision defines “transaction” to include a series of transactions. The Joint Committee noted that courts, when applying the Doctrine, will still have the ability to aggregate or disaggregate transactions as they deem necessary. Thus, courts will continue to maintain discretion over when they will apply the Doctrine and the number of steps in a transaction to which they will apply the Doctrine.

Given the relatively few exceptions provided plus the broad rule regarding “series of transactions,” one challenge facing taxpayers is determining whether a taxpayer’s proposed transaction is, or is not, subject to the Doctrine. Accordingly, a review of a broad range of prior court precedent may be warranted.

Under Section 7805(a) of the Code, the Secretary has general authority to prescribe rules and regulations necessary for the enforcement of any provision of the Code. Until the Secretary enacts rules or regulations and preferably safe harbors for the undefined or vaguely defined terms, the onus will be upon the courts to define those terms.

Satisfying the Economic Substance Doctrine

The Joint Committee on Taxation explained that a taxpayer may, but is not required to, rely on profit potential to satisfy either prong of the Doctrine. A taxpayer may only rely on potential profit if the expected present value of pre-tax profits is substantial compared to the expected present value of net tax benefits that would be permitted if the transaction were respected. Substantial is not defined. Additionally, the new provision does not require an actual minimum return.

When calculating expected pre-tax profits, the taxpayer must take fees and expenses into account. The provision requires the Secretary to issue regulations to treat foreign taxes as expenses in appropriate cases. This is another instance where the provision is not clear. The statute gives the Secretary discretion regarding which cases are appropriate. The Joint Committee noted that the provision is intended to allow the courts to consider the appropriate treatment of foreign taxes.

Taxpayers may be well advised to document, on a contemporaneous basis, their profit potential computations and any other factors which they could rely on to demonstrate that a transaction results in a meaningful economic change and that the taxpayer had a non-federal-income-tax purpose.

Penalty for underpayments and understatements attributable to transactions lacking economic substance

The new provision imposes a strict liability penalty for an underpayment attributable to a transaction that lacked economic substance. Section 6662 of the Code imposes a 20 percent penalty on any underpayment of tax attributable to certain malfeasance, such as negligence. The provision amends Section 6662(b) to include “any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.”

The penalty will increase from 20 to 40 percent on any underpayment attributable to a non-disclosed noneconomic substance transactions. In a non-disclosed noneconomic substance transaction, the transaction lacks economic substance and the taxpayer has failed to adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return. Non-disclosure cannot be cured by an amended return or supplement to a return if filed after the taxpayer received notice for audit.

The reasonable cause exceptions in Section 6664 will not apply to underpayments attributable to a transaction that lacked economic substance. The Joint Committee noted that under the provision, outside opinions or in-house analysis would not protect a taxpayer from imposition of a penalty if it is determined that the transaction lacks economic substance or fails to meet the requirements of any similar rule of law.

A claim for refund or credit that is excessive under Section 6676 due to a claim that is lacking in economic substance will be subject to the 20 percent penalty, and again this is a strict liability penalty. Therefore, the reasonable basis exception of Section 6676 is not available.

Finally, these penalties do not apply to any portion of an underpayment that is subject to a fraud penalty.

Unearned Income Medicare Contribution

Effective Dates

The Unearned Income Medicare Contribution applies to taxable years beginning in 2013.

Rate of Tax

For individuals, the Unearned Income Medicare Contribution tax (the UIMC Tax) adopted in the Reconciliation Act imposes an additional 3.8 percent tax on the lesser of:

(A) net investment income, or

(B) the excess of

(i) the modified adjusted gross income, over

(ii) the threshold, which is $250,000 for joint filers ($125,000 for married filing separately and $200,000 for all other returns)

Thus, if the taxpayer does not have modified adjusted gross income in excess of the threshold amount, then that taxpayer will not be subject to this tax.

The UIMC Tax also applies to estates and trusts, but does not apply to a non-resident alien or to a trust whose unexpired interests are devoted to charitable purposes. Further, the UIMC Tax does not apply to a trust that is exempt from tax under section 501 of the Code or a charitable remainder trust exempt from tax under section 664 of the Code.

Net Investment Income

Net investment income is the sum of:

(i) gross income from interest, dividends, annuities, royalties and rents, other than income derived in the ordinary course of a trade or business

(ii) gross income derived from passive activity (within the meaning of Section 469) with respect to the taxpayer and income from a trade or business of trading financial instruments or commodities (as defined in Section 475(e)(2)), and

(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business reduced by the deductions properly allocable to such income.

Gains may only be offset by losses of the same type of income. For example, passive losses may not offset income from dividends and visa versa. This is similar to the limitations found in Section 469. (For example, under Section 469 of the Code, an individual may not use losses from passive activities to offset gains from portfolio activities).

Income derived in the ordinary course of a trade or business does not include passive activity (within the meaning of Section 469) with respect to the taxpayer and a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).

Gross income does not include items such as interest on tax-exempt bonds, veterans’ benefits, and excluded gain from the sale of principal residence, that are otherwise excluded from income.

In the case of the disposition of an interest in a partnership or S corporation, only the net gain or loss attributable to property held by the entity that is not attributable to an active trade or business is taken into account in determining net investment income.

It should be noted that losses or expenses that offset the specific items of income described above, should have additional value since they will offset this new 3.8 percent tax.

Modified Gross Income

The Reconciliation Act defines modified adjusted gross income as adjusted gross income increased by the amount excluded from income as foreign earned income under Section 911(a)(1) (net deductions and exclusions disallowed with respect to the foreign earned income).

Payments

The UIMC Tax is subject to individual estimated tax provisions, and is not deductible in computing income taxes.

Other Key Tax Increases

Several other key tax increases include the following:

• Repeal of certain deductions allowed to employers which sponsor qualified retiree prescription drug plans. Currently, employers receive a federal government subsidy of the cost of such prescriptions, and the subsidy is not included in taxable income. The new rule, effective for years beginning after December 31, 2012, requires that the subsidy be taken into account when computing the amount of tax deductions attributable to such plans. Although this provision Act takes effect in 2013, the loss of the deduction may require disclosure on public company financial statements in 2010.
• The imposition of a 2.3 percent excise tax on manufacturers and importers of certain medical devices, as defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act, which are intended for humans. The excise tax does not apply to eyeglasses, contact lenses, hearing aids or other devices determined to be generally purchased by the public at retail. The excise tax applies to sales after 2012.
• Beginning in 2014, US citizens and residents will be required to maintain basic health care coverage. Those who fail to maintain minimum coverage will be subject to certain penalties. 
• In addition, significant changes are made to the taxation of the health insurance industry, so-called Cadillac health insurance plans, the pharmaceutical industry and health flexible spending accounts, among others.

The Act is complex and subject to clarification under forthcoming regulations, and this Alert is intended only as a brief overview of several key tax issues.

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For more information on DLA Piper’s Health Care practice generally, please contact Senator Tom Daschle, Tom Boyd, Kimberly K. Egan and James P. Rathvon.

Please read our other Alerts on ways health care reform may affect your business.