Tuesday, May 25, 2010
The President signed § 7701(o) of the Internal Revenue Code, the first U.S. statutory general anti-avoidance rule, or “GAAR”, into effect on 30 March 2010. The birth of the American GAAR was buried in § 1409 (a) of the Health Care and Education Reconciliation Act of 2010 (H.R. 4872). With § 7701(o) the muster of common law jurisdictions without GAARs is dwindling. India and the UK remain prominent hold-outs.
Section 7701(o) applies to “any transaction to which the economic substance doctrine is relevant”. A standard GAAR says that an avoidance transaction is void for tax purposes and authorizes the Commissioner to reconstruct the transaction and to tax that notional reconstruction. The economic substance doctrine operates similarly. It tells the Commissioner to disregard legal transactions and instead to tax the economic substance beneath.
The Obama GAAR has extra bite. It strikes down a transaction where the economic profit is not “substantial” in relation to its net tax benefits.
This relative benefits rule was presumably intended to reverse the result in cases like Compaq Computer Corp v. Commissioner, but the drafting of § 7701(o) betrays all sorts of compromises. Paragraph (5)(C) says: “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.” Congress seems to be saying, “We may appear to have armed the Commissioner with a GAAR. But we don’t really mean it. Everyone carry on as before”. But that interpretation is too bizarre to be tenable. On the contrary, § 7701(o) is a true GAAR that will prove a powerful weapon in the hands of the Commissioner. Notwithstanding its novel drafting, it will operate much as GAARs do in other common law jurisdictions. Like GAARs elsewhere it will become a focus of scholarly writing.