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What Is Economic Substance Law

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Please note Bedell Cristin`s detailed briefings and “best tips” available on our website and contact one of our specialists for more information or advice. The Cayman Law and Guidelines on SEEs can be found here. The economic substance doctrine is a common law legal doctrine that does not allow the tax benefits of a transaction if the transaction has no economic substance or commercial purpose. The doctrine was codified in 2010 in Article 7701(o), which defines a transaction as having an economic substance if (1) the transaction significantly changes the taxpayer`s economic situation (apart from its impact on federal income tax); and (2) the taxpayer has a material purpose (other than those tax implications) to enter into the transaction. An entity (with the exception of a holding company and companies engaged in intellectual property transactions for which there are different criteria) carrying out a relevant activity must meet the economic substance requirements if: (1) it needs to develop a more local substance; or (2) must be a tax resident in another jurisdiction. The origins of a transaction, including how it was formed and negotiated and why, are relevant because they speak to the “economic reality” of the transaction. In Frank Lyon Company v. United States[6], for example, it was significant that the transaction involved several independent organizations involved in a tendering procedure. The negotiations, described as “good faith”, included a comparison of the different proposals; and the transaction was non-family and non-private throughout the transaction. The court concluded that there was an economic substance. Meeting the rules on the substance requires an international perspective, as many affected businesses will need a global tax residency exam. Planning for the regulation of substances could also have an impact on the position of the companies concerned under the Common Reporting Standard and FATCA.

Businesses that are tax residents outside the Cayman Islands are not required to have or report on an economic substance, but must file an annual notice and form proving their tax residency. Paragraph 6662(b)(6) imposes a penalty for insufficient payment due to tax benefits that were not permitted because a transaction under paragraph 7701(o) has no economic substance or does not meet the requirements of a similar rule of law. According to the IRS, “like rule of law” means a rule or doctrine that uses the same factors and analyses as under Sec. 7701(o) for an analysis of economic substance, even if another term (p.B. “fictitious transaction doctrine”) is used to describe the rule or doctrine. While all relevant entities will be required to submit a submission containing information on their business activities, a scope entity will only have to comply with the assessment of the economic substance if it carries out a “relevant activity”. The relevant activities in each country are as follows: Although there are differences in how each country concerned has legislated to address the problem of “economic substance”, the approach has been broadly consistent. Where substantive requirements now exist, the requirements do not apply to all businesses, but to those that carry out certain “relevant activities”. Economic substance is a doctrine of U.S. tax law that a transaction must have both an essential purpose in addition to reducing the tax liability and an economic effect in addition to the tax effect to be considered valid. This doctrine is used by the Internal Revenue Service to determine whether tax havens or tax liability reduction strategies are considered “abusive”. [1] According to the doctrine, for a transaction to be complied with, the transaction must alter the taxpayer`s economic situation “significantly” in parallel with the effects of federal income tax, and the taxpayer must have had a “substantial purpose” to carry out the transaction, other than the effects of federal income tax.

[2] According to the code cluster`s assessment, any non-European jurisdiction (which includes Bermuda, the British Virgin Islands, the Cayman Islands, Guernsey, the Isle of Man and Jersey) was required to address the Code Group`s “economic substance” concerns. [1] The roots of the theory of economic substance go back to 1935. See Gregory v. Helvering, 293 U.S. 465 (1935). [5] Idat (o)(5)(C) (“The determination of the relevance of the economic substance doctrine to a transaction is carried out in the same manner as if this subsection had never come into force.”). This common law doctrine prohibits tax benefits for a transaction if the transaction has neither economic substance nor commercial purposes. In essence, that doctrine states that, for a transaction to be effective, it must have an economic purpose other than the reduction of the tax liability and that it must also have an effect other than its tax effect. The economic substance doctrine exists for the Internal Revenue Service (IRS) to determine whether tactics to reduce tax liability (also known as tax havens) are abusive or not. While the doctrine of economic substance has recently been codified, the principles underlying Article 7701(o) have been evolving for decades.

When taxpayers report the impact of transactions on their tax returns, they and their tax professionals should assess whether the transaction will persist under the economic substance doctrine or whether they will face significant penalties. Blue J Tax`s economic substance classifier asks you to complete a questionnaire about the facts of your scenario. Each of the questions represents a factor that influences the Tribunal`s decisions on whether the economic substance test is met. Once you have answered all the questions, Tax Foresight calculates the probability that the transaction has an economic substance and compares your scenario with the previous relevant cases. The result of such a discovery can be serious. A taxpayer responsible for transactions without economic substance is liable to a general penalty of 20% of the prohibited tax benefits associated with the transaction. [2] In case of insufficient disclosure of the relevant facts concerning the activity of non-economic substances, the penalty is increased to 40%. [3] Taxable persons cannot invoke objections based on “valid grounds” when they are subject to one of these sanctions. [4] When conducting the test, courts consider the origin, structure and economic impact of the transaction.

Factors related to the impact of the transaction, which are not profit, and the amount of risk assumed by the taxpayer in connection with the transaction may also be relevant. The IRC defines the doctrine of economic substance as “the common law doctrine under which … Transactions are not permitted if the transaction has no economic substance or no commercial purpose. [3] According to the Code, the doctrine applies only to transactions “related to a business, business or activity carried on to generate income.” [4] Although the doctrine was codified in IRC § 7701(o), common law principles that developed long before its codification remain relevant because these common law principles – even under the law – determine whether or not an economic substance exists. [5] If a corporation has been established in a relevant jurisdiction and carries on a “relevant activity”, it must comply with the substantive requirements, unless it can prove that it is resident for tax purposes in another jurisdiction. Failure to comply with the requirements will result in significant fines and/or cancellation of the company. 1. First, it is necessary to examine whether an undertaking or other legal person liable to be affected carries out a `relevant activity`. 2. If this is the case, in most cases there will be two possible answers if it is considered that the company does not have sufficient substance: the extent of the taxpayer`s exposure to the risk is also relevant to determining whether the transaction was in good faith. In the Frank Lyon Company,[13] the taxpayer assumed the risk of depreciation of the building, the liability for a large land rent and the risk of default of the tenant. A majority of the Supreme Court held that it was important that obligations and risk exposure should rest exclusively with the taxpayer and his or her business.

[14] The Court considered the taxpayer`s level of risk and concluded that this was a genuine transaction with an economic substance imposed by economic circumstances. [15] According to this doctrine, for a transaction to be accepted, the taxpayer`s economic situation must be significantly affected by that transaction, with the exception of the effects of federal income tax […].

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