NYSBA Tax Section Recommends More Guidance on Codification of Economic Substance Doctrine

Among other things, where the ESD is "relevant," Section 7701(o) mandates a conjunctive test for economic substance and sets forth a statutory standard for profit potential. To encourage taxpayer compliance with Section 7701(o), Section 6662 was amended to impose a 20 percent strict-liability penalty (increased to 40 percent absent adequate disclosure) on understatements attributable to tax benefits denied under Section 7701(o) or any "similar rule of law" (the "ESD Penalty").

On September 13, 2010, the Treasury Department and the Internal Revenue Service issued Notice 2010-62, which offers some guidance, but includes a statement that the government does "not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply." We believe, however, that the potential imposition of the ESD Penalty is reason to articulate certain basic principles, including that certain common law formulations related to the ESD, and sometimes used alternatively in the case law, are nevertheless distinct. We believe these distinctions are important to provide the Service and courts clear and uniformly applicable guidelines, permitting a finding against the taxpayer in appropriate cases without implicating the ESD Penalty, while allowing imposition of the ESD Penalty (by application of the two-prong test described in the statute) in cases for which it was intended. We therefore encourage Treasury and the Service to issue guidance clarifying, among other things, that certain existing legal doctrines do not fell under the statutory definition of the ESD, and we believe that this can be done without limiting the government's or the courts' ability to continue to develop the ESD on a case by case basis in the future.

Furthermore, to provide taxpayers and field-level agents of the Service with as much direction as possible, we believe that Treasury and the Service should also issue guidance clarifying to the extent feasible other specific aspects of Section 7701(o), such as in respect of the profit potential test. We believe this is desirable from the standpoint of both the government and taxpayers as potential litigants, as well as in respect of the principle that a fair and efficient tax system should allow taxpayers to conduct their affairs with reasonable knowledge of what the tax laws are, especially where the consequences of being wrong include an automatic, strict-liability penalty. Section 7701(o) and the ESD Penalty provisions contain certain newly articulated concepts and the wording is in certain places unclear and confusing.

The following is a brief summary of our recommendations for guidance:

• Guidance clarifying that, for purposes of Section 7701(o), the ESD refers only to judicial rules of statutory construction that deny the tax benefits of a transaction if a court has analyzed both the economic substance and business or non-tax purpose of such a transaction (or at least has referred to the applicability of such a two-prong test) and found it lacked either or both. Specifically excluded would be other doctrines, such as substance over form, step transaction and adequate business purpose (in the sense where it is used separately from the ESD).

• Similarly, guidance clarifying the meaning of the phrase "any similar rule of law" in Section 6662(b)(6), to the effect that a rule of law is not a similar rule of law if it is not based on an analysis of both the economic substance and non-tax purpose of the transaction in question (regardless of whether the court expressly found that either or both was lacking), and coordinating the ESD Penalty with the precise scope of the ESD along the lines suggested above.

• Guidance enunciating a few principles identifying broad categories of transactions to which the ESD (as defined in Section 7701(o)(5)(A)) is not "relevant." In particular, these principles would confirm that the ESD is not relevant to (i) any tax elections granted to taxpayers under the Code or the Treasury Regulations, and (ii) where the circumstances of the transaction are such that the tax benefits are "clearly consistent" with the provisions and purposes of the Code or Regulations.

• Given how important the test for potential pre-tax profit of Section 7701(o) is likely to be, guidance as to the proper application of the present value concepts under the provision, including how to determine what discount rate or rates are to be used.

• If feasible, guidance under Section 7701(o)(2) addressing (i) which expenses (e.g., actual or imputed financing costs) should be taken into account under the provision, and under what circumstances; and (ii) the application of Section 7701(o)(2) to transactions whose economics are based (in part or largely) on tax benefits arising from specific incentives granted by Congress.

• Guidance that either confirms that foreign income taxes should not be treated as "expenses" for purposes of the Profit Potential Test or details the limited situations in which they should be.

• Although current LB&I practice providing that the ESD Penalty is not assertable without the express review and consent of an IRS District Counsel is a laudable first step, at least until the courts, Treasury or the IRS provide further clarification, the ESD Penalty should not be assertable without express review and consent of the IRS Chief Counsel.

• Guidance aligning the disclosure requirements of Section 6662(i) with the administration of the substantial understatement penalty of Section 6662(b)(6).

• Respectfully submitted,

   

   

  Peter H. Blessing

   

  Chair

   

  New York State Bar Association

   

  Tax Section

   

I. Overview and Summary of Proposals.

Our reports on previous codification proposals of the ESD⁴ expressed the concern that taxpayers and Internal Revenue Service ("IRS") agents would require guidance as to when the ESD and any attendant penalties should properly apply, and that formulating such guidance would not be easy.⁵ Now that codification has occurred and taxpayers and the IRS have to work with its concepts, we find it necessary to ask for specific guidance in certain areas.

On September 13, 2010, Treasury issued Notice 2010-62, which offers brief, interim guidance. Notice 2010-62 is helpful as an official confirmation of public statements by various senior IRS and Treasury officials that, in their view, the enactment of Section 7701(o) should not be viewed as a sea change in the scope of the doctrine,⁶ though at the same time the Government is not limited in trying to extend the doctrine on a case-by-case basis, even in fact patterns where it may not have been successfully invoked before. While we agree with this view, it does not alleviate the need for guidance in certain key respects. The automatic applicability of the ESD Penalty (in effect, a dramatically higher tax rate on affected transactions) creates a need for some definition or clarification of the scope that simply did not exist to the same degree before. The ESD Penalty is truly a sea change.

Further, Section 7701(o) and the ESD Penalty do contain newly articulated concepts and the wording is in certain places unclear and confusing, and would benefit from guidance at least as much as any other new statutory provision. In those areas, Notice 2010-62 does not shed enough light and, for the reasons we set out below, we hope that Treasury and the IRS can quickly provide more substantial guidance clarifying the new provisions and how the IRS will administer them.

As discussed below, one of our major concerns, especially given the nature of the ESD Penalty, is the potential for honest misuse of Section 7701(o) by the IRS. In the absence of some guidance as to when the IRS can appropriately raise Section 7701(o), it would not be surprising to see field-level IRS agents raising it routinely in taxpayer audits, which obviously would have detrimental consequences for the tax system.

We are aware that many in government, as well as some in the private sector, have opposed the promulgation of a so-called "angels list" of transactions or types of transactions that are per se exempt from attack under Section 7701(o).⁷ Furthermore, Notice 2010-62 includes a statement that the government does "not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply."⁸ We recognize the concerns that animate this position; however, we also believe that clarifying the proper scope of Section 7701(o), Section 6662(b)(6) and Section 6662(i) is important and reasonable for taxpayers to request. Accordingly, we encourage Treasury to issue guidance confirming at least that certain existing legal doctrines do not fall under the statutory definition of the ESD, and we believe that this can be done without limiting the government's or the courts' ability to continue to develop the ESD on a case-by-case basis in the future. Furthermore, to provide taxpayers and field-level IRS agents with as much direction as possible, we believe that Treasury and the IRS should also issue guidance clarifying to the extent feasible other specific aspects of Section 7701(o) as discussed herein.

For reasons evident from the discussion below, we believe that guidance is needed in respect of the Profit Potential Test, from the standpoint of the government and taxpayers as potential litigants, as well as the general standpoint that a fair and efficient tax system should allow taxpayers to conduct their affairs with reasonable knowledge of what the tax laws are, especially where the consequences of being wrong include an automatic, strict-liability penalty. Notice 2010-62, which says that the government will "apply existing relevant case law and other published guidance,"⁹ is simply not enough. The courts do not bring cases and generally do not raise the ESD on their own initiative. Thus, it is no more than fair to ask the government to articulate, at least in a broad sense, what standards it intends to apply. An objective of the legislation was consistency in application of the ESD by the courts, and that objective would be served by guidance on certain fundamental issues.

The following is a brief summary of our recommendations for guidance by Treasury and the IRS:

• Guidance clarifying that, for purposes of Section 7701(o), "the" ESD refers only to judge-made rules of statutory construction that deny the tax benefits of a transaction if a court has analyzed both the economic substance and business or non-tax purpose of such a transaction (or at least has referred to the applicability of such a two-prong test) and found it lacked either or both. Specifically excluded would be other doctrines, such as substance over form, step transaction and adequate business purpose (in the sense where it is used separately from the ESD). This is important given that the literal wording of Section 7701(o)(5)(A) could otherwise be read to expand the ESD to any transaction where the taxpayer needs only the most minimal of business purposes (and economic substance is not evaluated or referred to at all).

• Similarly, guidance clarifying the meaning of the phrase "any similar rule of law" in Section 6662(b)(6), to the effect that a rule of law is not a similar rule of law if it is not based on an analysis of both the economic substance and non-tax purpose of the transaction in question (regardless of whether the court found that either or both was lacking). Such guidance should also coordinate the ESD Penalty with the scope of the ESD as more precisely articulated along the lines suggested above.

• Guidance enunciating a few principles identifying broad categories of transactions to which the ESD (as defined in Section 7701(o)(5)(A)) is not "relevant." In particular, these principles would confirm that the ESD is not relevant to (i) any tax elections granted to taxpayers under the Code or the Treasury Regulations, and (ii) where the circumstances of the transaction are such that the tax benefits are "clearly consistent" with the provisions and purposes of the Code or Regulations. (Nevertheless, in the appropriate situations, a court could hold that the ESD is relevant to a series of transactions that include one or more elections on the ground that the election is being used in a way inconsistent with Congressional intent, or a court could strike down an election or transaction under another doctrine of U.S. tax law.)

• Given how important the pre-tax profit test (the "Profit Potential Test"), of Section 7701(o) is likely to be, guidance as to the proper application of the "present value" concepts under the provision, including how to determine what discount rate or rates are to be used.

• If feasible, guidance under Section 7701(o)(2) addressing (i) which expenses (e.g., actual or imputed financing costs) should be taken into account under the provision, and under what circumstances; and (ii) the application of Section 7701(o)(2) to transactions whose economics are based (in part or largely) on tax benefits arising from specific incentives granted by Congress.

• Guidance that either confirms that foreign income taxes should not be treated as "expenses" for purposes of the Profit Potential Test or details the limited situations in which they should be.

• Although current LB&I practice¹⁰ providing that the ESD Penalty is not assertable without the express review and consent of an IRS District Counsel is a laudable first step, at least until the courts, Treasury or the IRS provide further clarification, we believe that the ESD Penalty should not be assertable without express review and consent of the IRS Chief Counsel.

• Guidance aligning the disclosure requirements of Section 6662(i) with the administration of the substantial understatement penalty of Section 6662(b)(6). Among other things, in addition to the guidance provided by Notice 2010-62, this guidance should explain that disclosure will be considered "adequate" for purposes of Section 6662(i) if it supplies the information required by Revenue Procedure 2010-15.¹¹

Over time, in attempting to grapple with the question of Congressional intent and whether more is going on than gaining tax benefits, the ESD, as with other aspects of the tax law, has grappled with and come to incorporate time value concepts, albeit not consistently or with uniform results. For example, early in the development of the law regarding leveraged lease transactions, the Tax Court suggested in Hilton v. Commissioner,²⁰ in dictum, that the ESD should be applied by using a 6% compounded discount rate. In its per curium affirmance of the Tax Court's decision, the Ninth Circuit weakened the authority of the Tax Court's dictum by observing, "we deem the six percent rate to be for illustrative purposes only. No suggestion of a minimum required rate of return is made."²¹ Subsequently, in the often-cited case of Estate of Thomas v. Commissioner,²² the Tax Court retreated from its position in Hilton because it did not "feel competent, in the absence of legislative guidance, to require that a particular return must be expected before a 'profit' is recognizable. . . . Our sole task here is to determine whether a profit was reasonably likely on these facts in order to find that tax avoidance was not the sole motivation for the transaction."²³ (We understand that for decades, until recently, these authorities provided the principal guidance on which responsible tax practitioners have based their opinions on such transactions.)

A principal difficulty with Hilton, Estate of Thomas and their progeny is that the courts in these cases never specified which discount rates might be used. Indeed, many courts have upheld lease transactions without requiring a discounting of profit.²⁴ To some extent, in the leasing arena at least, it seemed that courts accommodated this uncertainty by permitting risk-adjusted discount rates to be utilized in situations where they found the transactions to be abusive on other grounds, as part of the justification for treating the transactions as lacking in economic substance.²⁵ In the meantime, initially outside of the context of leasing transactions, a contrary view, stemming primarily from the landmark case of ACM Partnership v. Commissioner,²⁶ emerged that "present value adjustments are, as the courts have recognized, an appropriate means of assessing the transaction's actual and anticipated economic effects."²⁷ Although there may be a legitimate argument that this principle is merely dictum, and should be limited, for example, to the valuation of liquid investments, it has recently been used in a high profile case to support the discounting of cash flows arising from a leveraged lease transaction at the taxpayer's cost of funds.²⁸ Whatever lingering debate there may have been about applying time value concepts generally in the ESD context, however, has been resolved. Section 7701(o)(2) now provides a clear directive that all "relevant" transactions must be tested using present value concepts if the taxpayer seeks to rely on the Profit Potential Test.

Finally, we also note that the ESD is not applicable ("relevant") to deny tax benefits arising from every tax-motivated transaction that lacks a business purpose or economic substance or both. As we observed in the 2000 Report and the 2003 Report, given its role as a rule of statutory and regulatory interpretation, the courts have historically denied tax benefits under the ESD only if allowing them, under the taxpayer's particular circumstances, would be contrary to the intent of the drafters of the relevant statute or regulation. For instance, in Cottage Savings Ass'n v. Commissioner,²⁹ a taxpayer entered into a tax- motivated transaction (i.e., an exchange of economically similar mortgage portfolios) solely for the purpose of accelerating the deduction of an otherwise unrealized economic loss. Notwithstanding that the exchange lacked a non-tax business purpose and did not meaningfully change the taxpayer's economic position, the Supreme Court refused to disallow the deduction on the grounds that the transaction did qualify as an "exchange" under the terms of Section 1001 and the regulations thereunder and that the Commissioner did not convince the Court that Congress and Treasury could not have reasonably contemplated the availability of a loss deduction under these circumstances.

We took a similarly critical position in our 2003 Report with respect to the 2003 Proposal, which, with certain important exceptions, was generally consistent with the basic framework of Section 7701(o) and amended Section 6662. We argued in our 2003 Report that the literal provisions of the 2003 Proposal, like those of the 2000 Proposal, would have unwarranted and unintended effects on a wide range of common, and legitimate, business transactions. We also argued that the 2003 Proposal, if enacted, would require a massive regulatory project, and that a wholesale delegation of rulemaking responsibility to Treasury by Congress would be irresponsible, as well as ineffective.

Finally, earlier this year, the current House Rules Committee decided to include a codification proposal, along with certain related enforcement measures, in its health care reconciliation package.³² On March 30, 2010, as part of Congress' comprehensive overhaul of the national health care system, the President signed the Reconciliation Act into law.

The House Budget Committee's report on the Codified ESD (the "House Report")³³ explains the pre-enactment state of the law as follows:

• the transaction in question meaningfully changes the taxpayer's economic position (apart from federal income tax effects), and

• the taxpayer has a "substantial purpose" for entering into the transaction (apart from federal income tax effects).

In the context of the Profit Potential Test, both the House and Joint Committee Reports provide that Section 7701(o)(2)(A) "does not require or establish a specified minimum return that will satisfy the profit potential test."³⁶ This contrasts starkly with previous codification proposals. These prior proposals would have required not only that the present value of the reasonably expected pre-tax profit from a transaction be substantial in relation to the present value of the transaction's expected net tax benefits, but also that such pre-tax profit exceed a "risk-free rate of return."³⁷ As we discuss further below, it is unclear just what to make of this. Seemingly, Congress recognized the interplay between profit and other non-tax factors in the ESD inquiry and wanted to clarify that even when a taxpayer relies wholly or partly on pre-tax profit, the necessary level of profit cannot be specified in the abstract without analyzing the facts and circumstances of the particular case. Thus, for example, a different level of pre-tax profit might be required in transactions supported by certain tax-independent considerations other than the transaction's profitability, particularly where those other considerations do not satisfy the ESD standing alone.³⁸ Similarly, consistent with its requirement that cash flows be discounted to a present value, Congress might have intended to incorporate the flexibility established by the cases that declined to impose any particular pre-tax return requirement. As those cases, particularly Estate of Thomas v. Commissioner,³⁹ deferred to future Congresses to supply a specific return requirement, it would follow that Congress would have to explain that the statutory profit test neither requires nor establishes a specified minimum return.

Beyond the "no specified minimum" comment, the House Report and the Joint Committee Report do not shed much light on how to apply the Profit Potential Test; nor does Notice 2010-62. Nevertheless, some taxpayers may try to parse the reports closely (notwithstanding the issues as to their status as authority)⁴⁰ and will note that the reports summarize prior case law as follows, using identical text and, with one potentially meaningful (or merely confusing) exception, identical footnote citations:

To describe prior case law in the first of the above-excerpted texts, the Joint Committee Report cited Wells Fargo & Co. v. United States⁴⁷ in its footnote 312 for the proposition that a reasonable possibility of pre-tax profit must exist. In that case, in holding that various "sale-in-lease-out" or "SILO" transactions lacked profit potential, the Court of Federal Claims took the taxpayer's overall cost of capital into account.⁴⁸ As we discuss below, the question of whether indirect costs (either specific costs or a general or overall cost of capital) should be taken into account in calculating pre-tax profit is, at least under one approach to the Profit Potential Test, fundamental. Hence, given that the Joint Committee Report subsequently omitted any citation to Wells Fargo in footnote 356, explaining the new statutory test may lead some taxpayers to argue, rightly or wrongly, that omission evidences an intent to overrule, limit or, at the least, not fully endorse that decision. Others, who take a different view of the Profit Potential Test, may say that Section 7701(o) has independently resolved this aspect of the dispute in Wells Fargo because, as we discuss below, under that view a cost of funds (at some rate) would be automatically imputed.⁴⁹

In addition, some may argue that footnote 356 of the Joint Committee Report, which references and purports to explain the same text as footnote 137 in the House Report, limits the amount of pre-tax profit required by the new statutory test. In footnote 356, the Joint Committee Report, in its explanation of the statutory profit formulation, did not repeat its citation to the cases that it (like the House Report) had cited as standing for the proposition that the "profit potential must be more than nominal" as compared to tax benefits (i.e., Goldstein and Sheldon).⁵⁰ Rather, the Joint Committee Report cited the cases -- except for Wells Fargo -- that it had earlier cited, in footnote 312, as standing for the proposition that "it may be sufficient if there is a nominal amount of pre-tax profit as measured against expected tax benefits" (i.e., Rice's Toyota World, Compaq and IES).⁵¹ On balance, however, to many of us, the reasons for footnote 356's citing to the cases (other than Wells Fargo) in footnote 312 and yet omitting Wells Fargo are, frankly, unclear. The statute is clear, however, that a substantiality comparison is required for the Profit Potential Test.

In not including a minimum pre-tax return requirement, Congress has opened up the possibility that, at least in certain cases, a taxpayer's pre-tax rate of return need not exceed its overall cost of funds (unless of course, those costs are properly directly attributable to the transaction). This possibility would suggest that the holding in Wells Fargo is not necessarily endorsed. Or, more narrowly, because, among other things, Wells Fargo involved fully defeased lease transactions in which the court viewed the taxpayer as being insulated from any meaningful risk of loss, perhaps footnote 356 suggests that where the taxpayer's investment is exposed to material risk (or other tax-independent factors are present unlike the facts in Wells Fargo), Congress intended to leave open the possibility that a lesser pre-tax return may be sufficient.

Alternatively, another possible, and more straightforward, interpretation of footnote 356 is that the Joint Committee Report merely intended to provide case authority for the statutory requirement that the requisite profit be reasonably expected.⁵² This view would tend to minimize the significance of this footnote being different from footnote 137, though it seems like an obvious point. Other interpretations are of course possible, and, in any event, it may be unwise to attempt to parse legislative history in such an exacting manner.

This leads us to pose a question that we think helps to illuminate the fundamental tensions at play in determining how to interpret Section 7701, and the Profit Potential Test in particular. As we understand it, responsible taxpayers have typically premised their mixed-motive transactions on the notion that more than a "reasonable possibility of pre-tax profit" has been required and that the transactions have to be reasonably expected to yield a significant, periodically compounded, internal rate of return. For transactions to which Section 7701(o) applies, i.e., not ones where the tax results are "clearly consistent"⁵³ with the Code, Regulations and Congressional intent, did Congress intend to change the treatment of such transactions?

Take such a transaction that is reasonably expected to generate a meaningful and positive pre-tax economic yield, but one that (after reduction for all direct transaction cost, but disregarding any indirect financing costs and disregarding any expected tax benefits) is less than the taxpayer's own allocable overall pre-tax cost of funds. If the after-tax yield is attractive, a rational taxpayer, absent any other (including ESD) constraints, will enter into this transaction if it offers a favorable after-tax yield, as compared to other investments and the taxpayer's allocable after-tax cost of funds. This transaction invokes the Mixed-Motive Principle at its simplest, because the taxpayer relies on both tax benefits and pre-tax cash flows. Post-codification of the ESD, however, if the Profit Potential Test is understood to impute indirect funding costs broadly to reduce the amount of pre-tax profit or to require, in determining the numerator for the Profit Potential Test, a net present valuing of cash flows, using the taxpayer's overall pre-tax cost of funds as the discount rate, the taxpayer's mixed-motive transaction may very well not survive Section 7701(o) scrutiny, unless the result is clearly intended by Congress, because it will have no "pre-tax profit."⁵⁴

Alternatively, many would argue that in light of the more recent ESD cases, if a transaction results in a pre-tax loss (taking into account all economically allocable expenses), Congress intended that taxpayers would only be able to secure tax results of such a transaction if they were consistent with the intent of Congress. Most of us believe that, given the case law developments over the past 10 years (or more), this is not a large change in prior law and it will not inhibit a large number of normal business transactions.

Much of what we explore in this Report is, in essence, tied to the foregoing example and these related questions. Is Section 7701(o) meant merely, perhaps, to raise the bar somewhat and to make the test more uniform? That is, when the result is not clearly intended by Congress, is Section 7701(o)'s goal to make sure that the profit is not de minimis, to require that present value concepts are always used and that the size of the expected tax benefits is also taken into account -- but not effectively to prohibit this type of transaction? If so, how can Section 7701(o) be applied without creating a wide opening for potentially abusive transactions? Or, is Section 7701(o) meant to permit mixed-motive transactions only when they are clearly consistent with Congressional intent, and how is the scope of Congressional intent to be identified and applied predictably? It is curious that Congress did not provide greater lucidity on this issue.

Although some taxpayers assert that these authorities, while not purporting to construe the ESD, imply that tax equity financings that satisfy the guidelines will satisfy the ESD,⁵⁷ as well as the Codified ESD, and one might easily question whether the government would be constrained by these guidelines if it decided to challenge transactions under the Codified ESD. The government has argued in a number of cases that the leasing guidelines do not address whether leasing transactions satisfy either the ESD or, implicitly, the Codified ESD.⁵⁸ Similarly, the wind energy guidance only applies, by its terms to the issue of whether the transaction's tax allocations satisfy Section 704(b), and those regulations clarify that they do not address whether allocations meet ESD requirements.⁵⁹ Finally, even if the leasing and flip partnership guidelines were recognized as exempting transactions from the Codified ESD, even those guidelines are not broad enough to cover many leasing and flip partnership transactions that are currently being done in the marketplace.⁶⁰ Hence, many taxpayers are left to wonder whether, as under prior practice, a pre-tax internal rate of return ("IRR") in the range of roughly 2-4% will generally be deemed sufficient if these transactions are indeed subject to Section 7701(o) and not clearly intended by Congress. In one of the SILO and lease-in, lease-out ("LILO") cases decided before Wells Fargo and the enactment of Section 7701(o), a federal district court held that the transactions satisfied the ESD on the strength of a pre-tax profit that was in line with that practice.⁶¹ This concern is exacerbated by the committee reports attempting to explain the Profit Potential Test solely by reference to existing case law, without clarifying what it means for profit to be more than nominal or how it must be present valued, and not explaining whether or not Congress intended for the Profit Potential Test to effect a change of this sort.

If Treasury and the IRS determine that the better interpretation of the Profit Potential Test would, if applied to leasing and tax equity financing transactions that are not abusive but are nonetheless not clearly intended by Congress, radically and inappropriately harm that industry, then the Government may want to address those sorts of transactions with specific guidance, such as an update to the leasing, wind energy and similar guidelines or other means, that would instruct taxpayers as to the proper method for conducting those transactions such that they were sufficiently economic to be viewed as "appropriate" and not in violation of Section 7701(o). Treasury and the IRS may identify other potentially affected industries.

More broadly, strict-liability penalties do not sit harmoniously with so-called living doctrines -- that is, evolving, dynamic aspects of the law, like the ESD. In the case of Section 7701(o), there are additional issues, such as whether or not codification of the ESD has in principle, or effectively in practice, overruled the presumptions at the heart of the Mixed-Motive Principle with respect to transactions that will have to rely on the Profit Potential Test. We believe that, because the ESD Penalty heightens the stakes involved in the difficult task of discerning the dividing lines, guidance in certain areas is even more appropriate.

III. Analysis of Specific Provisions.

None of the House Report, the Joint Committee Report or Section 7701(o)(5)(A) itself clarifies the intended scope of the statutory definition of the ESD. In fact, the House Report observes that the statutory definition "includes any doctrine that denies tax benefits for lack of economic substance, for lack of business purpose, or for both."⁶⁴ It is unclear whether the plain language of the statute is consistent with this statement, and this statement also cuts against other indications of Congress' views in the Reconciliation Act's legislative history. Further, Section 7701(o) purports not to alter or supplant any other rule of law, "including any common-law doctrine or provision of the Code or regulations or guidance thereunder."⁶⁵

Nonetheless, given the plain language of the statutory definition, it is possible that an IRS agent could interpret Section 7701(o)(5)(A) quite broadly. Under such an approach, "the" ESD could include, for purposes of Section 7701(o), any doctrine under which at least one court has ruled that a transaction requires some sort of business purpose -- "substantial" or not and regardless of whether such transaction has been previously thought to involve the familiar two-prong ESD analysis -- in order for the consequences of the transaction to be respected for tax purposes. Any such transaction would be susceptible to attack under Section 7701(o) on audit, forcing the taxpayer to defend the transaction's tax benefits either by demonstrating that the transaction satisfies the Codified ESD Test or by arguing, for instance, that it has been respected under "longstanding judicial and administrative practice."⁶⁶ Given the nature of the ESD Penalty, one need only think of the Cottage Savings transaction before the Supreme Court's ruling to understand that, absent guidance, this could change the stakes for ordinary forms of traditional tax planning in ways we think were clearly not intended by Congress.

We are aware, of course, that various judge-made doctrines -- the ESD, the business purpose doctrine, and the basic common-law principle of "substance over form" -- are not always easy to distinguish under pre-Reconciliation Act law.⁶⁷ They are, however, in fact, distinguishable, and we do not believe that Congress intended the rubric of the ESD as codified by Section 7701(o) to encompass these other doctrines. We believe that guidance can and should harmonize the words of Section 7701(o)(5)(A) with the underlying policy of the Codified ESD Test (i.e., denying unintended tax benefits derived from "empty" transactional forms) and legislative intent.

A brief survey of Subchapter C, for instance, reveals a litany of authorities applying the step transaction doctrine or the "substance over form" principle without even attempting to evaluate the economic substance of the transaction in question.⁶⁸ None of these cases or the doctrines articulated in them should be viewed as examples of cases where the ESD was used to determine the result. Nor is this concept limited, of course, to Subchapter C. A recent example in the Subchapter K arena is Canal Corporation and Subsidiaries v. Commissioner,⁶⁹ where the Tax Court found a disguised sale to have occurred because the purported indemnity written by one partner, who had hoped that the existence of the indemnity would increase its share of the partnership's liabilities under Section 752, was found to create "no actual economic risk of loss."⁷⁰

Accordingly, we recommend that Treasury issue guidance providing that Section 7701(o)(5)(A) incorporates only the existing judicial doctrine that repudiates abusive tax results by applying a two-prong analysis -- whether that is articulated by asking (i) if the transaction had an economic effect and whether there was a non-tax purpose or (ii) if the transaction had an economic effect or whether there was a non-tax purpose. (We refer to this inquiry as "Two-Prong Economic Substance Analysis.")

For instance, clarifying that the statutory definition of the ESD refers only to judge-made rules of statutory construction will sweep out a host of anti-abuse rules under the Code or the Treasury Regulations that serve other anti-abuse functions. A contrary result, we believe, is clearly at odds with the legislative intent behind the statute and would create needless uncertainty for taxpayers. For instance, placing statutory or regulatory anti-abuse rules on a par with the ESD for purposes of Section 7701(o) would fly in the face of the ESD's traditional role as a true "backstop" to the Code and the Treasury Regulations, and would be a fundamental and unintended shift that is not even mentioned as a possibility in the House or JCT Reports.

This will also preclude the awkward possibility, discussed above, that "the" ESD could literally include any doctrine under which at least one court has ruled, without ever discussing or considering economic substance, that a transaction requires some sort of minimal business purpose in order for its consequences to be respected for tax purposes. We believe that Congress did not intend Section 7701(o)(5)(A) to embrace, for example, the relatively light business purpose analysis that one court has applied to otherwise garden-variety Section 351 exchanges.⁷¹

Furthermore, we believe that such guidance should also expressly provide that other doctrines, such as "substance over form," "adequate business purpose" and "step transaction" are not, standing alone, examples of the ESD, and instances where courts have applied such concepts (and not engaged in Two-Prong Economic Substance Analysis) are not ESD cases. This would provide a better delineation that would allow the IRS, taxpayers and judges to know with more accuracy when the ESD Penalty is to be applied, while allowing the IRS and courts to continue to invoke other doctrines that have been traditionally applied to strike down transactions with much less uncertainty about whether or not the ESD Penalty should or should not apply. In that vein, we discuss the ESD Penalty next.

The legislative history of the Reconciliation Act makes it clear that taxpayers are truly strictly liable for the ESD Penalty. For instance, according to the House Report:

The scope of Section 6662(b)(6) needs to be as clear as possible in order to provide taxpayers with fair notice and limit, to an appropriate degree, the ability of field-level IRS agents to assert the ESD Penalty. Unfortunately, the intended reach of the ESD Penalty is unclear from the amended statutory text of Section 6662. Particularly troubling, we believe, is the inherent elusiveness of the phrase "any similar rule of law," which is underscored by certain inconsistencies in the Reconciliation Act's legislative history. For instance, the House Report observes that the ESD Penalty "would apply to a transaction that is disregarded as a result of the application of the same factors and analysis that is [sic] required under the provision for an economic substance analysis, even if a different term is used to describe the penalty."⁷⁸ This language differs from the corresponding footnote in the Joint Committee Report, which refers more broadly to the application of "similar" (not necessarily "the same") factors and analysis.⁷⁹ The House Report also omits language from the Joint Committee's technical explanation of the 2003 Proposal indicating that Congress' primary focus was on other judge-made doctrines.⁸⁰ Given these uncertainties, it is unclear whether the IRS could impose the ESD Penalty with respect to a transaction that fails, for instance, a statutory or regulatory anti-abuse rule that is not the historic ESD or the Codified ESD Test going by another name.⁸¹

Under new Section 6662(i), the ESD Penalty is increased, from 20 percent to 40 percent, in the case of any portion of an underpayment attributable to "one or more nondisclosed noneconomic substance transactions."⁸² For these purposes, the term "nondisclosed noneconomic transaction" includes any portion of a transaction described in Section 6662(b)(6) (i.e., any transaction lacking economic substance, as determined under Section 7701(o), or failing to meet the requirements of any similar rule of law) "with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return."⁸³

Thus, whether the increased 40 percent ESD Penalty applies with respect to a particular transaction turns on the concept of "adequate" taxpayer disclosure. Neither the House Report nor Section 6662(i) itself indicates what constitutes adequate taxpayer disclosure for purposes of the new ESD Penalty provisions.⁸⁴ However, because the language of Section 6662(i) tracks that of Section 6662(d)(2)(B),⁸⁵ we believe that the new provision should be interpreted in a manner that is consistent with Treasury's administration of the substantial understatement penalty under Section 6662(b)(2).

The Reconciliation Act did not codify a comprehensive scheme for administering the ESD Penalty. By contrast, the 2007 Proposal included a number of express administrative rules, including a chain-of-command system for reviewing and approving an IRS agent's assertion and compromise of the ESD Penalty. The Senate Finance Committee's report on the 2007 Proposal summarized these provisions as follows:

We recommend that Treasury issue guidance addressing these important substantive and procedural aspects of Section 6662(b)(6) and (i). Perhaps most importantly, such guidance should clarify the meaning of the phrase "any similar rule of law" in Section 6662(b)(6). Specifically, we propose that the ESD Penalty not be assertable:

• on or with respect to a denial of tax benefits under any provision of statutory or regulatory law (e.g., Section 269, the partnership anti-abuse rule of Treas. Reg. Section 1.701-2, or the original issue discount anti-abuse rule of Treas. Reg. Section 1.1275-2(g)), unless the lack of economic substance is independently determined; or

• with respect to any transaction to which the ESD (as defined in Section 7701(o)(5)(A)) is considered not relevant for purposes of the Codified ESD Test.

• a similar rule of law is only one where the Traditional Two-Prong ESD analyses has been applied (regardless of the labels employed by the court); and

• other non-statutory doctrines that do not repudiate abusive tax results by virtue of the underlying transaction's fundamental lack of economic substance (e.g., "step-transaction" or "substance-over-form" recharacterization) are not similar rules of law.

Finally, we agree with Treasury guidance in Notice 2010-62 aligning the disclosure requirements of Section 6662(i) with Treasury's administration of the substantial understatement penalty of pre-Reconciliation Act Section 6662(d)(2)(B) (without regard to Section 6662(d)(2)(C)) and that disclosure is to be made on Form 8275 or 8275R.

Notice 2010-62 provides that:

Section 7701(o) provides that the determination of whether the ESD is relevant to a transaction must be made in the same manner as if the statute had never been enacted.⁹¹ In this connection, the Reconciliation Act's legislative history provides a number of helpful interpretive insights. For instance, according to the House Report, Section 7701(o) "does not change current law standards in determining when to utilize an economic substance analysis."⁹² Instead, if the tax benefits in question are "clearly consistent" with all applicable provisions of the Code, as well as the purposes of such provisions, "it is not intended that such tax benefits be disallowed if the only reason for such disallowance is that the transaction fails the economic substance doctrine."⁹³

The House Report also observes that the enactment of Section 7701(o) will not affect the status of certain basic transactions that have traditionally not been considered subject to the ESD:

As part of our 2003 Report, we provided an illustrative list of transactions that we, as practitioners, considered essentially uncontroversial under the traditional conception of the ESD, but that could have been swept within the reach of (and would likely have flunked) the 2003 Proposal's version of the Codified ESD Test.⁹⁷ Unlike the enacted version of the Codified ESD Test, the 2003 Proposal's version appeared to have almost unlimited application. By contrast, the enacted version of the Codified ESD Test applies only if the ESD is relevant to the transaction in question, a limitation that we believe Congress intended to have real consequences. We believe that Treasury and the IRS can and should exercise their regulatory authority under Section 7701(o) to explain the principles behind, and the limits to, Section 7701(o).

We recommend that Treasury set forth a few principles identifying broad categories of transactions to which the ESD (as defined in Section 7701(o)(5)(A)) will not be considered relevant. We believe that this approach finds ample support in both the legislative history of the Reconciliation Act and Section 7701(o) itself. The House Report indicates that Congress intended Treasury and the IRS to have broad powers to implement Section 7701(o), and the "relevance" limitation of Section 7701(o)(1) invites explanation. To be clear, Treasury would not be ruling that the transactions covered by such principles generate unassailable tax results, rather, this guidance would merely make it clear that such transactions cannot be attacked using Section 7701(o) and the strict-liability penalty of Sections 6662(b)(6) and (i). The proper conceptual approach to this guidance should reflect certain common sense principles that we believe will ultimately make Section 7701(o) more administrable. We propose that these principles be expressly included in Treasury's guidance. This guidance could be supplemented with specific examples.

• First, the guidance should clarify that all tax elections granted to taxpayers under the Code or the Treasury Regulations are exempt from scrutiny under Section 7701(o). These "transactions" can have neither economic substance nor any sort of business purpose, apart from achieving a desired set of tax results.⁹⁸ Further, all acts that can be accomplished by such an express election should similar be beyond challenge under Section 7701(o).⁹⁹ Nevertheless, of course, in appropriate situations, e.g., when the overall result is inconsistent with Congressional intent, a court could hold that the ESD is relevant to a series of transactions that includes one or more of these sorts of elections.

• Second, consistently with the legislative history, the guidance should clarify that the ESD is not relevant if the tax benefits arise in circumstances that are clearly consistent with the provisions and purposes of the Code or Regulations. To supplement that clarification, guidance could clarify situations where the ESD is relevant; for example, among other circumstances, where tax benefits are generated in a way that, although it satisfies the technical or literal requirements of the Code or Regulations, the result is to shelter or offset income generated by one or more unrelated transactions and the circumstances are such that Congress or Treasury could not reasonably have intended the benefits to be available under the relevant provisions of the Code or Regulations.

• the transaction changes the taxpayer's economic position "in a meaningful way" (apart from federal income tax effects) (the "Economic Effect Test"),¹⁰⁰ and

• the taxpayer has a "substantial purpose" for entering into the transaction (apart from federal income tax effects) (the "Substantial Purpose Test").¹⁰¹

Thus, Section 7701(o)(2) puts crucial importance on the Profit Potential Test. A transaction that is relying on profit potential and that fails the test will fail the ESD unless the taxpayer can make the difficult showing that the result of the transaction is clearly intended by Congress. On the other hand, a transaction that satisfies the test is automatically protected from application of the ESD, even if the result of the transaction is clearly inconsistent with the intent of Congress. It is therefore critical to draw the line in a reasonable place.

Although it is clear that if the taxpayer does choose to rely on the transaction's profit potential to satisfy either or both of the Economic Effect Test and the Substantial Purpose Test, the profit potential will be taken into account only if the "present value" of the reasonably expected "pre-tax profit" from the transaction is "substantial" in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.¹⁰⁶ Beyond this point, however, very little about the Profit Potential Test is clear.

Although, as we discuss below, the words of Section 7701(o)(2) are far from self-executing, very generally, we think, in enacting Section 7701(o)(2), that Congress was saying that to rely on the Profit Potential Test in situations where the ESD is relevant (i.e., the tax benefits are not manifestly "clearly consistent" with all applicable provisions of the Code and their purposes), then the tax benefits should be permitted only where there was a reasonable expectation that, on a time value basis, the taxpayer would earn a positive return, not counting tax benefits. In addition, to distinguish the new test from some prior courts' decisions, the new statutory test also mandates that the return (on a time value basis) must be substantial in comparison to the expected federal income tax benefits. Hence, in a very rough way, we think one could say that the Profit Potential Test means to ask "Is there meaningful profit to be expected?" -- while also understanding that it is the value of the tax benefits that move the transaction from "meaningfully" profitable to "much more" profitable. Beyond this rough paraphrasing, however, lies confusion and disagreement.

Practitioners and commentators have long understood that the question of whether (and in what way) time value of money should be taken into account in assessing a transaction's profit potential poses a conceptual conundrum at the core of the ESD. If future pre-tax cash flows must be discounted at a fixed rate, for example 6% per annum, then an investment that has a per annum expected pre-tax IRR that is lower than that discount rate, as it will have a negative net present value, must be seen as having no pre-tax profit potential. On the other hand, a transaction with, for example, a 2%, 3% or 4% expected pre-tax IRR might very well pass muster under the pre-Section 7701(o) ESD on the ground that, in keeping with Frank Lyon, pre-tax IRR of that size constitutes a substantial economic interest that proves the transaction is not shaped and motivated solely by tax avoidance. Courts have unquestionably decided that a pre-tax profit is required for cash flows that do not need to be discounted, but at the same time, many courts and taxpayers have understood that setting the requisite economic return as applied to future cash flows is necessarily arbitrary and raises some basic tax policy concerns.¹¹⁰ Without guidance from Treasury or the IRS, it seems unclear whether or not Section 7701(o), although clarifying that time value concepts must be used, has settled the most fundamental aspect of this conundrum.

The disagreement over exactly how to apply the Profit Potential Test can be summarized as follows:

• The PV of Profit Approach: This interpretation would argue that the statute makes most sense, in the context of the Mixed-Motive Principle, including Supreme Court cases like Frank Lyon, and the House and Joint Committee Reports' explanation that no minimum return is required or established to satisfy the Profit Potential Test, if it is applied literally: calculate reasonably expected pre-tax profit (i.e., net cash flow in excess of expenses) on an undiscounted basis, discount it to present value, do the same for the expected tax benefits, and compare the former to the latter. If the former (the present value of the reasonably expected pre-tax profit) is substantial in comparison to the latter (the present value of the expected tax benefits), then the Profit Potential Test is passed; if not, it is failed. Literalism is, however, not always (or perhaps even usually) the best approach to interpreting an anti-abuse rule, and certainly is not compelled in this case.¹¹¹

• The Net Present Value Approach: Given the explicit introduction of present value principles in the statute itself, an alternative interpretation is to treat a transaction as "profitable" only if the net present value ("NPV") of the cash flows from the transaction is positive. A transaction would therefore satisfy the Profit Potential Test only if the NPV of all pre-tax cash flows is "substantial" relative to the NPV of the expected tax benefits. This approach, of course, does effectively require the return to be greater than the discount rate, though the choice of that rate may vary from case to case, with no minimum set, because any return that does not exceed the discount rate will end up generating a negative net present value and will, hence, automatically fail the Profit Potential Test. On the other hand, it has the advantage of simplifying most if not all of the issues relating to imputation of indirect financing costs.¹¹²

If Congress intended the Profit Potential Test to be satisfied only in the case of transactions that are expected to generate a positive NPV in accordance with the Net Present Value Approach, then it may have intended to impute a portion of the taxpayer's total aggregate financing costs to every transaction (similar, for example, to the allocation of interest expense under the uniform capitalization rules of Section 263A). A Net Present Value Approach typically discounts future cash flows at the taxpayer's cost of funds, which can include its cost of equity capital, even if the taxpayer funded the transaction in question on a debt-free basis; however, the Net Present Value Approach also could be applied by discounting at a different rate, as a court may determine is appropriate.

If Congress instead intended the Present Value of Gross Profit Approach, it is not clear whether financing costs should be treated as transaction expenses only when directly incurred in the transaction or whether all transactions must have the taxpayer's implicit cost of funds treated as a transaction expense.

Relying on the case law, with no further guidance, to divine which financing costs to be taken into account for purposes of the statutory Profit Potential Test does not seem to us the proper answer. For many years, courts did not impute a cost of capital, whether debt or equity, as an item of expense when looking to see if a transaction was entered into with an adequate profit potential.¹¹³ In Casebeer v. Commissioner,¹¹⁴ the Ninth Circuit held that interest on recourse purchase money notes, which were incurred to finance computer lease transactions and secured by the leased equipment, was properly taken into account for purposes of calculating the leases' pre-tax profit potential. The court rejected -- apparently as a factual matter -- the taxpayers' argument that their decision to incur recourse indebtedness "was based on an analysis of their entire portfolio rather than on isolated transactions," instead finding that the notes constituted an "element" of the leases.¹¹⁵

With similar effect, but a divergent analysis, in Wells Fargo & Co. v. United States,¹¹⁶ the Court of Federal Claims held that various "sale-in-lease-out" or "SILO" transactions did not satisfy the ESD, among several other grounds for disregarding those transactions. For purposes of calculating the pre-tax profit potential of the SILO transactions, the court effectively took the taxpayer's overall cost of capital into account.¹¹⁷ The approach espoused in Wells Fargo if applied broadly, would represent a fundamental change in this area. As discussed in Section II(C) above, it is not at all clear from the legislative history that Congress rejected (or endorsed) this approach; nor is it clear whether this result will be upheld on appeal.¹¹⁸

In any event, we think that there is a noncontroversial starting point. At a minimum, financing costs directly related to a project should be taken into account, including, for example, costs associated with debt secured by relevant property or incurred by a special purpose vehicle used for the transaction or series of transactions. In fact, there is long-standing administrative precedence for adopting the "directly related" concept as the definitive requirement: since 1975, the IRS's guidance on advance rulings for leveraged leases have required only that "direct costs to finance" an equity investment are to be taken into account.¹¹⁹ (The leasing guidance, of course, is not an interpretation of the Potential Profit Test, or even the ESD more broadly, despite occasional taxpayer arguments to the contrary.)

The further question of whether expenses of a general and unrelated nature, such as a business' overall cost of capital, including both debt and equity, should be treated as expenses of the transaction when examining a mixed-motive transaction is more difficult. In the interests of transparency and fair tax administration, we encourage Treasury and the IRS to articulate a workable standard for when indirect financing costs will be taken into account for purposes of the Profit Potential Test.

Given that nothing in the statutory formulation of "fees and other transaction expenses" expressly includes the cost of financing and the legislative history is silent, one approach would be to read covered "transaction expenses" narrowly and to clarify that only where such costs are directly connected to the transaction in question should they be taken into account for purposes of the Profit Potential Test. Under this approach, the taxpayer would have to demonstrate, under general principles of tax law, that it did not incur the financing costs in connection with, or for the purpose of financing, the transaction in question. In applying this standard, only if the taxpayer has incurred specific costs to fund the transaction (and, if the planning is successful, generate the desired tax benefits) should the costs reduce the pre-tax profit. Under this approach, it may be instructive to consider the attribution standards in Sections 246A, and 265(a)(2), as well as the IRS's lease ruling practice, to determine when the funding may be incurred for the purpose of investing in the transaction subject to ESD scrutiny (the "Relevant Investments").¹²⁰ The "directly attributable" standard of Section 246A(d)(3)(A) (though there based on the legislative history), is used to attribute indebtedness to the purchase or carrying of portfolio stock otherwise eligible for a favorable dividends-received deduction, which was enacted to prevent the abuse of taxpayers deducting interest expense on attributable indebtedness against largely untaxed dividends.¹²¹ One might also look to the authorities under the "incurred or continued to purchase or carry" standard of Section 265(a)(2), given that the purpose of that standard is to prevent tax-exempt income from being funded by a deduction-generating source.¹²²

Under this approach, Treasury and the IRS might also consider a variety of authorities interpreting Sections 246A and 265(a)(2), that use "nonpurposive" principles that could be used in combination with, or in lieu of, the above "purposive" attribution principles so as to limit or expand their range of application. These include whether (a) the Relevant Investments are directly traceable¹²³ to the incurrence of the funding; (b) the Relevant Investments could not have been made "but for" the incurrence or continuation of the funding or are otherwise directly economically dependent upon such incurrence or continuation; and (c) the Relevant Investments are part of a business or activity that is not economically distinguishable from the business or activity in which the funding is incurred or continued, e.g., because the need for the funding is determined (or "dominated") by the (non-tax) requirements of such other business or activity. The number of these principles is large, as is their possibly appropriate combinations.

This "direct only" approach is by no means compelled, however, and significant arguments can be made against it. In the first place, perhaps a broader imputation of interest costs rule should be looked to as a model. Section 263A(f)(2)(A)(ii), for example, uses the so-called avoided-cost method. Using that approach as a model, perhaps it would be appropriate to allocate all interest expense to reduce pre-tax profit to the extent the taxpayer's interest cost would be deemed reduced had the transaction not been undertaken. Under this approach, the amount of interest deemed attributable to the transaction would not depend on whether the taxpayer actually would have used the amounts otherwise invested in the transaction to repay or reduce debt. Instead, the avoided-cost method is based on the assumption that debt of the taxpayer would have been repaid or reduced without regard to the taxpayer's subjective intentions or to restrictions (including legal, regulatory, contractual, or other restrictions) against repayment or use of the debt proceeds.¹²⁴ Of course, in that respect, the avoided-cost approach is arguably quite distinct from Section 7701(o)'s instruction to take "fees and other transaction costs" into account, but, nonetheless, such an approach may avoid an unduly limited approach to interpreting what as an economic matter such costs are.

Furthermore, if indirect financing costs of a transaction are not taken into account, this means that the "profit" of a transaction for purposes of Section 7701(o) is higher than the true economic profit to the taxpayer. This in turn means that a transaction might satisfy the Profit Potential Test even though there is no real economic profit to the taxpayer. This would permit taxpayers to enter into transactions with no real economic profit, but with a definitional profit for purposes of the Profit Potential Test because indirect costs are not taken into account. The taxpayer might thereby obtain significant tax benefits not intended by Congress because the transaction would satisfy the Profit Potential Test and thus satisfy the Two-Prong Economic Substance Analysis. In determining whether to count all indirect costs (including, potentially equity costs) in the Profit Potential Test, the government must balance this concern from not counting those costs against the concern that, if all such costs are taken into account, it will be very difficult for many mixed motive transactions that are not of a type clearly intended by Congress to satisfy the ESD.

If the Net Present Value Approach to the Profit Potential Test is adopted, and if an assumed cost of debt capital is used as a single discount rate for all cash flows, then there would be no need to separately address the allocation of indirect costs of debt capital. Under that approach, the process of determining the net present value of the cash flows would produce the same result whether one imputes the indirect debt or not, as one would be treated as incurring a cost of capital on the equity portion equal to the cost on the debt-financed portion.¹²⁵ For example, if one assumes that a taxpayer is generally one-third debt financed at an average debt cost of 9%, and makes an investment of $100 that yields 10% per annum, a net present value calculation of the pre-tax cash flows that attributes the indirect financing costs should begin with a negative cash flow of only $66.67 (i.e., the portion of the investment not deemed funded by the indirect debt) and would have annual positive cash flows of only $7 (i.e., the $10 of gross yield minus 9% of the deemed debt-funded portion, or $3). Likewise, the cash received at the end of the transaction should be reduced by the $33.33 needed to pay down the principal of the debt. On the other hand, of course, the determination of indirect financing costs, if any, would need to be made under the PV of Profit Approach. Furthermore, this determination also would need to be made under the Net Present Value Approach in any case in which the discount rate selected is different than the overall rate on the indirect financing (whether debt equity, or both). Finally, we acknowledge that this example assumes away difficult issues such as whether to determine the cost of debt financing on a group-wide basis, how to reflect different tenors of outstanding debt, and how to deal with fluctuations in the amount of and interest rates on relevant debt.

Particularly in light of Wells Fargo and Altria, the Treasury and the IRS may wish to consider whether and how a taxpayer's overall cost of capital should be dealt with, including, possibly, in the context of financing costs. Relevant policy questions include whether enterprises that raise capital with equity should be favored over those that use debt financing, whether a distinction between preferred stock and senior debt is sensible, and whether a transaction should automatically satisfy the ESD test if its when pre-tax profits, when calculated giving limited or no effect to indirect costs, are substantial in relation to tax benefits.

We understand that it would be typical, from the standpoint of a common equity holder, to treat a fixed or floating rate preferred instrument return as a financing cost, and therefore we believe that it may be appropriate to treat such a return on an instrument issued by, for example, a special purpose vehicle, or on a preferred instrument issuance that is connected with the transaction in question, as a financing cost. Many of us find it difficult, however, to view the "costs" of common equity as a transaction cost, in the sense of "fees or other transaction costs." Rather, we think that accounting for the cost of common equity capital is properly done through whatever discounting mechanism is applicable under the statute, as discussed further below.

In any event, absent guidance, disputes between the IRS and taxpayers over attribution of borrowing to the investment seem inevitable, and no single method seems a priori correct. Hence, although depending on one's view as to the intended sweep of Section 7701(o), broader or narrower approaches to cost imputation seem defensible, it is likely more important that Treasury clarify if one (or more) of these, or some other approach, is the one it favors.

Like previous codification proposals, Section 7701(o) provides that, for purposes of calculating pre-tax profit, fees and other transaction expenses will be taken into account as expenses.¹²⁶ In a nod to the IRS's ultimate loss in both Compaq Computer Corp. v. Commissioner¹²⁷ and IES Industries, Inc. v. United States,¹²⁸ the statute also directs Treasury to issue Treasury Regulations requiring foreign taxes to be treated as expenses in "appropriate cases."¹²⁹ As we believe that there are few, if any, such cases, this approach is a welcome departure from the approach of previous codification proposals, which would have made such treatment mandatory.¹³⁰

On balance, we are of the view that the Codified ESD should not properly be determined to be "relevant" to claiming foreign tax credits, at least not in other than unusual cases. Given the premise of the foreign tax credit system that a foreign income tax is in effect a substitute for a domestic income tax and the set of statutory and regulatory requirements and anti-abuse protections now in place (including the noncompulsory charge rules, the holding period requirements of Sections 901(k) and 901(l), the structured passive investment arrangement rules under Section 901, the new Section 909 anti-"splitter" rules and the partnership anti-splitter rules of 1.704-1(b)(4)(viii), one can make a strong argument that the Codified ESD is not an appropriate policing mechanism. This conclusion can be read into the holdings of the cases cited above, which in effect expressed this concept by not treating the taxes as an expense in testing profit. Further, we find it instructive that Notice 2004-19, 2004-1 C.B. 606, in withdrawing Notice 98-5¹³¹ following the decisions referenced above, and announcing a continuing desire to stop "abusive" transactions, did not invoke or even allude to the ESD. Rather, the Notice said:

To be sure, those and other changes to the Code and the Treasury regulations in recent years have been effective, in our view, to curtail on a going-forward basis types of transactions in which taxpayers have sought out foreign tax credits to use excess limitation in a manner deemed clearly inconsistent with Congressional intent, and future changes or fine-tuning no doubt would result and be similarly effective if other abusive transactions develop. The ESD in this area appears to be of relevance primarily as a litigating tool to sidestep the fact that such changes are not made retroactively. The IRS in Notice 98-5 did attempt to adopt rules analogous to the ESD to foreign tax credits (with treatment of foreign taxes as an expense as a key component), and abandoned the effort as the result of conceptual and practical difficulties. We see little benefit in attempting such a broad endeavor at this point. This is not to foreclose the possibility that sham-like cases might arise of a type not addressed by the regulations in which foreign tax credits may be involved and with respect to which the ESD may be appropriately invoked on a targeted basis. We are not aware of such cases today, and we therefore urge a limited application of the rule to address such cases if they are identified.

On the other hand, those who favor the PV of Profit Approach believe that the Profit Potential Test's use of the phrases "present value of . . . pre-tax profit" clearly has a different meaning than "net present value of pre-tax cash flows." In addition, they ask what purpose is served by the requirement that the present value of pre-tax profit be substantial in relation to the net tax benefits, if it is not intended to clarify the quantum of pre-tax profit that is essential to a legitimate mixed-motive transaction. These proponents believe that the Profit Potential Test should be interpreted as an appropriate balance between the refusal of the pre-ACM Partnership courts to impose time value concepts without Congressional instructions and the judicial use of those concepts by other courts (whether appropriately or not) -- in such a way that could cause historically accepted mixed-motive transactions to fail the ESD unless the transactions are deemed of a type clearly contemplated by Congress. (As discussed above, in both cases, one must determine which expenses are appropriately chargeable to the "transaction" so that the correct amount of "profit" (or the correct negative cash flows) is calculated in the first instance.)

Under the legislative history, no minimum return is "required" (i.e., a demarcation of below which the taxpayer fails) or "established" (i.e., a demarcation at (or above) which the IRS cannot challenge) for all cases, leaving the amount of return to be dealt with on a case-by-case basis. As discussed below, the PV of Profit Approach depends on the view that Section 7701(o) is to be read to preclude a requirement that the taxpayer reasonably expect at least a "risk-free" pre-tax rate of return.

A literal reading of Section 7701(o)(2)(A) might be supported based on this conclusion, the conclusion that the ESD is "relevant" to leasing and similar tax equity financing transactions, the fact that there is no indication that Congress intended to overrule Frank Lyon or, more generally, the Mixed-Motive Principle, and the concern that such transactions cannot adequately be defended on the basis that they are clearly intended by Congress. Under this approach, Congress clarified that no minimum return is established or necessarily required, and intended to bring some level of economic reality (i.e., time value concepts) to the ESD, but did not intend to eliminate legitimate mixed-motive transactions that could not be defended as clearly intended by Congress (and did not intend to create a special rule for leasing and similar tax equity financing transactions). Under this approach one should measure the "present value" of the (nominal, not itself discounted on a time value basis) "pre-tax "profit" in comparison to the "present value" of the projected net tax benefits" and deem the Profit Potential Test satisfied only where the ratio of one to the other is above some minimum amount.

However, as we discuss below, this approach could, if taken to the extreme, create results that would be antithetical to Section 7701(o)'s stated mission of "clarifying" and "enhancing" the ESD. Moreover, as we discuss below, the Net Present Value Approach better reflects how financial analysts typically determine the time value of cash flows and, thus, more clearly embodies that principle of the ACM Partnership case, particularly as it seems to have been applied in the Wells Fargo case.¹³⁴ Moreover, as discussed above, it also may prove to provide a relatively simple solution to the difficult questions raised over whether one should (and if so, how) impute the costs of indirect debt financing to reduce "pre-tax profit" for purposes of the Profit Potential Test.

These tensions inexorably lead to the question of whether Congress intended to grant a broad exclusion from the ambit of the Codified ESD for certain traditional leasing and similar tax equity financing transactions, among other categories of transactions previously presumed to be legitimate where the exemption for results not clearly intended by Congress is not available. The legislative history says transactions, including specifically "leasing transactions," must "continue to be analyzed in light of all the facts and circumstances," other than "certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages."¹³⁵ (This discussion¹³⁶ in the legislative history refers by footnote to, among other authorities, the Supreme Court's decision in Frank Lyon¹³⁷ which is generally relevant to every leasing case of which we are aware.)¹³⁸ One reasonable interpretation of this is that the Codified ESD applies (is relevant) generally to leasing and similar transactions.

And yet, there is no obvious support for the notion that Section 7701(o)(2)(A) was intended to invalidate broad categories of transactions that a wide variety of practitioners had previously considered appropriate and to which the IRS has not objected. This point is reinforced by the public statements of a number of senior Treasury and IRS officials confirming that those officials do not generally view Section 7701(o) as being intended to have this effect.¹³⁹ And nothing in the House Report or the JCT Report commands the Profit Potential Test, whether or not the Net Present Value Approach is adopted, to cause such a radical change. Indeed nothing in those Reports prevents the conclusion that leasing and similar tax equity financing transactions whose results are consistent with Congressional intent do not have to be tested in the first place.

Consistent with this, those of us who favor the Net Present Value Approach (including most of our Executive Committee) generally would not, at least without further specific Congressional or administrative action, expect Section 7701(o) to be applied in such a way as to change radically the economic bases for these transactions in their traditional manifestations (i.e., excluding, e.g., SILOs and LILOs). For example, the Net Present Value approach could in fact be applied (e.g., "based on all the facts and circumstances," in appropriate cases, using a very low discount rate might be authorized and the meaning of "substantial" might be small)¹⁴⁰ or the Codified ESD might be found to be simply not "relevant" to leasing and similar transactions that achieve results that are "clearly consistent" with the purposes of all (other) applicable provisions of the Code.¹⁴¹

On the other hand, absent favorable guidance from the Treasury or IRS, we suspect that many transactions that take intended advantage of Congressional tax incentives may be thought to be subject to the Profit Potential Test of the Codified ESD, and for those transactions and many others, the answer will remain unclear. Accordingly, we turn back to a more detailed examination of the computational issues raised by the Profit Potential Test.

The most obvious approach that such guidance might take would be acknowledging that it would be very odd to treat a transaction whose cash flows generate a negative net present value (at any "normal" discount rate) as having a positive "pre-tax profit" on a present value basis, to say that Congress meant to require that a net present value of all pre-tax cash flows (positive and negative) be calculated. Certainly, for example, a court might determine that this is the correct way to apply time value of money principles to the pre-tax profit requirement. Indeed, as we understand it, this approach would be more generally typical of how financial analysts would determine the time value of cash flows. The fact that it is not the most literal reading of the statute need not be a fundamental impediment, given that the legislative history's comment about not necessarily requiring a minimum return need not prohibit this approach assuming that this approach is adopted in such a way as to permit flexibility in choosing the discount rate.

Further supporting this approach is that fact that it does not require the taxpayer (or the IRS) to find a methodology to determine the times at which "profit" should be deemed to be paid. Second, one can point to the vagueness, discussed above, of the phrase "net tax benefits," which constitutes the "denominator" of the Profit Potential Test, as a demonstration that a purely literal interpretation of Section 7701(o)(2)(A), as with most any part of the Code, is of course neither necessary nor expected. Admittedly, however, interpreting the ambiguity inherent in "net tax benefits"¹⁴² is not as challenging as reading "present value of pre-tax profits" to mean "net present value of pre-tax cash flows," "pre-tax profit construed on a present value basis" or some other formulation that would achieve the result required by the Net Present Value approach.

Some question whether it is appropriate to attribute this level of imprecision to a statute which was, prior to its enactment, considered carefully by a number of Congressional committees, Treasury and bar, financial accounting and industry groups over a span of many years, and that Congress could have easily adopted words different from those that it did. This leads others to support the more literal, PV of Profit Approach: determine what the pre-tax profit is (i.e., the gross (non-discounted) cash outlays minus the gross cash inflows) and then discount that amount to the present, using an appropriate discount rate, and making reasonable assumptions about when such pre-tax profit will occur. This approach would allow a gross (i.e., undiscounted) pre-tax profit of (say) 2%-4% per annum to be discounted (for example, at some multiple of the AFR) and tested for "substantiality" against the present value of the net tax benefits.

Under the PV of Profit Approach, however, because one can calculate a discounted present value only by first establishing when the cash flows occur, one has to derive (or "invent") a methodology for determining the times at which profit should be deemed realized. The statute, of course, does not provide or even hint at when a taxpayer's investments and profit should be taken into account. Hence, even the PV of Profit Approach needs "non-literal" help.¹⁴³

As noted above, applying the Net Present Value Approach would mean that Section 7701(o) has the effect of raising the bar, at least in the case of traditional leasing or similar tax equity financing transactions, if the transaction in question were required to rely on the Profit Potential Test to satisfy Section 7701(o). Congress expressed no specific intent to do so, however, and we are not aware of Congress having even considered whether it was substantially expanding the scope of transactions that would fail an ESD analysis, nor certainly that it intended Section 7701(o) to disallow the typical tax benefits arising from conventional project financing, leasing and similar transactions, other than those considered abusive (apart from the quantum of profit potential). Hence, we recommend that Treasury and the IRS conduct modeling analyses in respect of certain types of transactions under various commercial scenarios. To the extent that guidance treating certain transactions of this type as satisfying the ESD is deemed appropriate, we recommend that Treasury and the IRS take those analyses into account in determining the appropriate construction of the Profit Potential Test and to what types of transactions it should apply.

On the other hand, using a discount rate determined by the taxpayer's overall funding costs (i.e., funding costs not directly related to a transaction) would have roughly the effect of reducing the present value of pre-tax cash flow or profit (as the case may be) by such funding costs. In addition, a discounting method that uses a taxpayer's own incremental or overall cost of funds as the discount rate would favor taxpayers (such as banks that pay no or very little interest to their depositors) that have an overall cost of funds that is less than prevailing interest rates.¹⁴⁴

Alternatively, perhaps a prevailing interest rate should be used, such as the AFR or a tax-exempt rate determined under Section 1288(b). If the statutory test is determined to require taxpayers to discount pre-tax profit, without taking into account their particular risks of earning that profit, then discounting at a prevailing interest rate, such as one determined by reference to risk-free rates (e.g., the AFR or some multiple thereof), may be more appropriate. Indeed, the statute mandates that the present value of the reasonably expected pre-tax profit must be determined, not the present value of all potential pre-tax profit. This suggests that the "profit" must first be adjusted to ensure that only what is reasonably expected is discounted. Further, by requiring reasonably expected profit to be discounted, the statute offers no suggestion that taxpayers need to use discount rates that accurately reflect their risks of earning less than what is reasonably expected.

As discussed below, based on our preliminary analysis of various hypothetical transactions, if the PV of Profit Approach is adopted, using a discount rate derived from a prevailing interest rate would permit many, if not all, of the transactions that have previously been considered legitimate under the ESD to pass the Profit Potential Test. However, we have also observed that many taxpayers have overall funding costs (as typically measured by a weighted average pre-tax cost of capital) that significantly exceed the range of interest rates that accomplish this result. On the other hand, if the Net Present Value Approach is adopted, transactions bearing a 2-4% IRR that were previously considered legitimate could easily fail the Profit Potential Test if either prevailing interest rates or the taxpayer's cost of funds is used to discount pre-tax cash flows. It thus can be seen how critical it is that Treasury and the IRS issue guidance concerning the extent to which such transactions must pass muster under the Profit Potential Test and if so how that test is to be applied. To the extent that they believe that Congress intended to invalidate such transactions going forward, basic tax policy (and fairness) would suggest that they should inform taxpayers. The strict-liability ESD Penalty makes that position even more compelling.

Discount rates are merely the rates of return on comparable investments that are chosen to permit a present valuation of a set of cash flows. Thus, a reasonable discount rate for pre-tax profit could be determined by looking at the pre-tax investment yields¹⁴⁵ on a non-tax-favored investment with a comparable level of risk.¹⁴⁶ Hence, a pre-tax discount rate clearly seems required for the pre-tax profit discount calculation.

Similarly, a reasonable discount rate for a stream of taxes and tax savings arising from a transaction could be determined by the after-tax investment yields on comparable, taxable transactions that have very little pre-tax cash flow. This rate, not surprisingly, would be an after-tax rate. This discount method, as a factual matter, would likely lead to discount rates that do not have a simple mathematical relationship with discount rates used to present value pre-tax cash flows for the profit ratio.

This investment-based method of determining a discount rate for tax flows is not the only one, however, and it suffers from the fact that yields on comparable, competitively bid tax-advantaged (i.e., legitimate mixed-motive) transactions are not readily available. An alternative method that is appropriate in transactions that take advantage of tax-timing benefits, such as those associated with accelerated cost recovery deductions, arises from the observation that these transactions are economically equivalent to loans from the government at a zero interest rate. Based on that observation, the present value of tax benefits may be determined by using the after-tax equivalent of then prevailing commercial borrowing rates.

It seems much more likely to us, however, that Congress intended that both the numerator and denominator employ the same discount rate, even if, in the abstract, a financial analyst would not derive the present value of tax benefits using a pre-tax discount rate. That is, given that the task mandated by the Profit Potential Test is a comparison of (a) the present value of pre-tax profit and (b) the present value of tax benefits, if the same discount rate is not used for both (a) and (b), then the comparison is of apples to oranges. We doubt the Congress intended such a result.

In our view, the determination of an appropriate rate for discounting tax benefits would benefit greatly from guidance by Treasury and the IRS.

Our analysis of the relationship between discount rates and substantiality thresholds has been sharpened by a numerical analysis of how Section 7701(o)(2)(A) might apply in practice. To that end, we have considered a number of examples of hypothetical investments and numerical modeling of their cash flows and tax benefits.¹⁴⁹ Because of the legal and financial complexity of this analysis, a discussion of which we believe is beyond a sensible scope for this Report, and because they depend on decisions that only the government or courts can make, we recommend that Treasury and the IRS and any other interested parties undertake such analyses. To the extent the PV of Profit Approach is deemed appropriate, and the Treasury and IRS do not think that the relevant transactions are exempt from ESD because the results are clearly intended by Congress, we think it would be instructive for Treasury and the IRS to examine a range of mixed-motive transactions that they view as non-abusive (e.g., with pre-tax IRRs that make the transactions unobjectionable) and apply a methodology and a range of reasonable discount rates and profit ratio thresholds to determine whether the Profit Potential Test would invalidate broad categories of these transactions. For example, if "substantial" means 30%, modeling could determine the discount rates (perhaps expressed as a multiple (e.g., 120%) of the AFR) that would be required to cause a transaction with a 2%, 3% or 4% (or higher) pre-tax IRR to fail the Profit Potential Test. Treasury and the IRS could decide, based on those results, on a safe harbor or definitive basis, where to set the meaning of "substantial" and what discount rate is appropriate. It also might shed light on whether or not the PV of Profit Approach is appropriate. If so, this modeling exercise would also permit Treasury and the IRS to examine which discount rates and profit ratio thresholds might cause the Profit Potential Test (to the extent required to be applied) to validate transactions that have historically conservatively been considered not sufficiently "economic." Obviously, it would be inappropriate to set these key parameters at levels that could have that effect.

In conclusion, unlike ESD interpretation and practice before Section 7701(o), which was based primarily on an assessment of the transaction's pre-tax IRR Section 7701(o), now seems to require both the IRS and taxpayers to make complex present-value determinations to apply the Profit Potential Test that could easily be the subject of extensive and excessively expensive disputes. We believe it would be highly beneficial to all if Treasury and the IRS would clarify the correct approach to, and the mechanics for making, these determinations as soon as possible, so that the parties to legitimate transactions can make modifications to their transactions to avoid exposure to the new strict-liability ESD Penalty.

We understand that the prevailing practice is to treat tax credits in the same manner as cash in computing pre-tax profit. Although it might render invalid many transactions previously believed to be acceptable, another alternative in some circumstances (e.g., some transactions involving the investment tax credit) might be to ignore the credits in calculating both the pre-tax profits and the net tax benefits. So long as Congress actually enacted such tax credits to encourage the specific type of investment or activity in question, we believe that both of these approaches are a reasonable accommodation under the Profit Potential Test,¹⁵¹ and we propose that the validity of one or the other be expressly confirmed in Treasury Regulations (albeit perhaps as a safe harbor and not a substantive legal principle).¹⁵² Further, for these types of transactions it might be appropriate for Treasury, just as it might be for leveraged lease and similar transactions, to establish safe harbors for when transactions of this nature are deemed to satisfy Section 7701(o) by specifying minimum amounts of genuine "at-risk" investment and profit without regard to tax benefits (e.g., a minimum, pre-tax IRR).

Unfortunately, the statute provides very little direction in this regard. Section 7701(o)(5)(D) provides only that, for all purposes of Section 7701(o) (including the determination of whether the ESD is relevant to a given fact pattern), the term "transaction" includes a series of transactions. The House Report indicates that Congress intended Section 7701(o) to preserve the analytical flexibility exercised by the courts in cases such as Coltec Industries Inc. v. United States¹⁵⁴ and ACM Partnership:

Unfortunately, neither the House Report nor Section 7701(o) itself indicates when aggregation or separation (either by the courts or by field-level IRS agents) is appropriate. For example, some have wondered whether the result in Shell Petroleum Inc. v. United States¹⁵⁸ might have been different if Section 7701(o) had been available to the government. We find nothing in the statute or the legislative history that suggest that Congress considered how a "transaction" should be defined in Shell-type fact patterns.¹⁵⁹

The Shell court ultimately held, over the government's objections, that the contributed "non-producing" assets, which had zero discounted net cash-flow value, did constitute "property" for purposes of Section 351(a). We do, of course, accept that the IRS is free to challenge, under Section 7701(o), whether stock is in fact issued in exchange for property in a purported Section 351 exchange with multiple contributions of assets. Indeed, Shell supports our general belief that the IRS may challenge, under Section 7701(o), the purported tax benefits of a transaction that may or may not satisfy the literal requirements of the Code or the Treasury Regulations as a factual matter.

The government may also argue that certain contributed assets that have no value are not sufficiently related to other contributed assets that have value, such that the contribution of the former in a purported Section 351 exchange is a separate "transaction" that must independently satisfy the Codified ESD Test. However, the tax benefit desired by the taxpayer in Shell was a double deduction for the same economic loss, once on the sale of the preferred stock received on the section 351 transaction and again later on the sale of the contributed assets. Were a new case to arise with facts similar to those in Shell, now that Section 362(e) has been enacted, the double deduction would not be possible. Thus, the Cottage Savings decision, allowing as it does the taxpayer to determine the timing of recognition of a genuine economic loss, might allow the single economic loss on the sale of the stock. However, this is not clear because unlike in Cottage Savings where the taxpayer retained no economic interest in the depreciated assets, the loss on the preferred stock in Shell was recognized at a time when the depreciated assets remained in a subsidiary in the Shell group in which Shell owned all the common stock so that Shell retained all the economic upside and downside on the assets. In any event, even if Section 7701(o) would not apply to the facts of Shell today because of the subsequent enactment of Section 362(e), this does not answer the question of whether Congress intended the contribution of the non-producing assets in Shell to be a "separate" transaction in a situation where the contribution did in fact result in a double deduction or other significant tax benefit.

While we generally agree that field-level IRS agents (and, of course, the courts) must be allowed to apply the Codified ESD Test in a way that accommodates novel fact patterns and multi-step transactions, we also believe that the discretion of the IRS to "disaggregate" transactions cannot be unfettered without leaving taxpayers at risk of open-ended and unpredictable challenges -- with the specter of the strict-liability ESD Penalty looming all the while. Ultimately, of course, many of the situations are likely to be so fact specific that the courts will have to be the ultimate arbiters, but we recommend that Treasury and the IRS should consider issuing guidance setting forth certain principles for determining whether disaggregation of a multi-step transaction is or is not inappropriate, while comporting with Congressional intent to preserve the analytical flexibility of Coltec. For example, we think Treasury and the IRS could consider providing that there generally would be no disaggregation if each step of the multi-step transaction is a "reasonable means" of accomplishing the non-tax purpose of the multi-step transaction, the multi-step transaction, taken as a whole, satisfies the Codified ESD Test, and that the overall result is consistent with the intent of Congress. Guidance reflecting this principle, which is far from exhaustive, should help to minimize the potential for IRS misuse of Section 7701(o), while being consistent with Congress' intent to support the Federal Circuit's approach in Coltec.¹⁶⁰

² Unless otherwise indicated, all "Section" references in this Report are to the Internal Revenue Code of 1986, as amended (the "Code"), and to the U.S. Treasury Department ("Treasury") regulations promulgated thereunder ("Treas. Reg." or "Treasury Regulations").

³ Pub. L. No. 111-152 (2010).

⁴See New York State Bar Association Tax Section Summary Report on the Provisions of Recent Senate Bills That Would Codify the Economic Substance Doctrine, 2003 N.Y. ST. B.A. TAX SEC. REP. 1032 (the "2003 Report"); New York State Bar Association Tax Section Report on the Treasury's Proposal to Codify the Economic Substance Doctrine, 2000 N.Y. ST. B.A. TAX SEC. REP. 977 (the "2000 Report").

⁵ More generally, our reports had expressed various reservations about codification of the ESD. Treasury and the IRS had similarly opposed such legislation. See, e.g., Economic Substance Doctrine Would Create More Problems Than It Solves, Says Korb, TAX NOTES TODAY (Tax Analysts), 2008 TNT 32-3 , Feb. 15, 2008 (comments of Donald Korb, former IRS Chief Counsel).

⁶See, e.g., Official Says Codifying Doctrine Will Not Materially Affect IRS's Enforcement Views, DAILY TAX REP. (BNA), 132 DTR G-1, July 13, 2010 (comments of William Alexander, IRS Associate Chief Counsel (Corporate)); Codification of Economic Substance Will Not Lead to Broader Application, Attorneys Say, DAILY TAX REP. (BNA), 106 DTR G-4, June 4, 2010 (same).

⁷See, e.g., No "Angel List" Guidance Planned for Economic Substance, Official Says, DAILY TAX REP. (BNA), 88 DTR G-8, May 10, 2010 (comments of Robert Crnkovich, senior counsel for Treasury's Office of Tax Policy).

⁸ Notice 2010-62, Section B.

⁹ Notice 2010-62, 2010-40 I.R.B. 411, § C.

¹⁰See LB&I (formerly LMSB) Directive LMSB-4-0910-024 (Sept. 14, 2010).

¹¹ 2010-7 I.R.B. 404 (Jan. 27, 2010).

¹²See, e.g., Saba P'ship v. Comm'r, T.C. Memo. 1999-359, at 120 (noting that the ESD is a "'canon of statutory interpretation that statutes should not be read to create "absurd results"'" (quoting Horn v. Comm'r, 968 F.2d 1229, 1239 (D.C. Cir. 1992))), vacated on other grounds, 273 F.3d 1135 (D.C. Cir. 2001).

¹³ 293 U.S. 465 (1935).

¹⁴ The "modern" ESD typically involves so-called tax shelters, where a transaction is entered into to generate a loss that will be used to offset income from some unrelated transaction or activity. See, e.g., ACM P'ship v. Comm'r, 157 F.3d 231, 248 n.31 (3d Cir. 1998) (citing Gregory, 293 U.S. at 468-69; N. Indiana Pub. Serv. Co. v. Comm'r, 115 F.3d 506, 512 (7th Cir. 1997); Kraft Foods Co. v. Comm'r, 232 F.2d 118, 127-28 (2d Cir. 1956)); see also Yosha v. Comm'r, 861 F.2d 494, 497, 500 (7th Cir. 1988) ("Many transactions are largely or even entirely motivated by the desire to obtain a tax advantage. But there is a doctrine that a transaction utterly devoid of economic substance will not be allowed to confer such an advantage. . . . Straddles that involve no market risks are not economically substantial straddles and hedges; they are artifices created by accomplices in tax evasion. . . .").

¹⁵ For instance, even though Congress has granted taxpayers the right to deduct expenses and losses, Congress presumably did not intend, in most contexts, to grant deductions for payments with no "substance" or "purpose" other than securing the deductions themselves. See, e.g., Goldstein v. Comm'r, 364 F.2d 734, 741 (2d Cir. 1966) ("[T]his provision should not be construed to permit an interest deduction when it objectively appears that a taxpayer has borrowed funds in order to engage in a transaction that has no substance or purpose aside from the taxpayer's desire to obtain the tax benefit of an interest deduction. . . .").

¹⁶ One thoughtful commentator gave this summary:

¹⁷See, e.g., ACM P'ship v. Comm'r, 157 F.3d 231 (3d Cir. 1998); ASA Investerings P'ship v. Comm'r, 201 F.3d 505 (D.C. Cir. 2000); Consol. Edison v. United States, 90 Fed. Cl. 228 (2009); AWG Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D. Ohio 2008).

¹⁸See, e.g., Altria Group, Inc. v. United States, 694 F. Supp. 2d 259, 285 (S.D.N.Y. 2010); Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (2010), appeal docketed, No. 2010-5108 (Fed. Cir. Apr. 16, 2010).

¹⁹ Of course, there is no agreement on what the starting point is for this comparison. Many would argue the ESD, properly applied, already was, or should be interpreted to be, fairly restrictive with respect to mixed-motive transactions. For those with that view, Section 7701, even if it does severely limit the Mixed-Motive Principle, does not necessarily represent a particularly large or new development in the law.

²⁰ 74 T.C. 305, 353 n.23 (1980), aff'd, 671 F2d 316 (9th Cir. 1982).

²¹ 671 F.2d 316, 317 (9th Cir. 1982). See also Sacks v. Comm'r, 69 F.3d 982, 991 (9th Cir. 1995) (citing Hilton, the court stated that an investor is not "bound to discount the future at the rate the Commissioner thinks prudent").

²² 84 T.C. 412 (1985).

²³Id. at 440 n.52. In addition, the Tax Court distinguished its discounting method in Hilton as "dictum in the context of circumstances bordering on the egregious." Id.

²⁴See, e.g., Consol. Edison Co. of N.Y., Inc. v. United States, 90 Fed. Cl. 228, 328-29 (2009); Johnson v. Comm'r, 11 Cl. Ct. 17, 36 (1986); Gefen v. Comm'r, 87 T.C. 1471, 1499 (1986).

²⁵See, e.g., Pacheco v. Comm'r, 57 T.C.M. (CCH) 739, 744 (1989); Sacks v. Comm'r, 64 T.C.M. (CCH) 1003 (1985), rev'd on this ground, 69 F.3d 982 (9th Cir. 1995). The district court in Altria Group v. United States adopted a different approach, in which it held that although an undiscounted profit might be sufficient to satisfy economic substance prong of the ESD, a jury is nevertheless free to take the taxpayer's cost of funds into account in determining whether it was motivated solely by tax avoidance. 694 F. Supp. 2d at 285. Under the Codified ESD, we expect that this approach will not likely be very relevant in the future, because, as discussed in Section III(E)(1) below, the legislative history indicates that taxpayers may rely on the Profit Potential Test, which now clearly involves present value calculations, to satisfy both prongs. See H.R. Rep. No. 111-443, at 298 & n.137 (2010); JCX-18-10, at 155 & n.356; see id. at 298; JCX-18-10 No. 7 (both reports state that "if a taxpayer relies on a profit potential, the present value of the reasonably expected pre-tax profit must be substantial in relation to the present value of the expected net tax benefits" (emphasis added)).

²⁶ 157 F.3d 231 (3d Cir. 1998).

²⁷Id. at 259 (citing, arguably out of context, the Ninth Circuit's opinion in Hilton, among other authorities).

²⁸ Wells Fargo & Co. v. United States, 91 Fed. Cl. 35, 82 (2010), appeal docketed, No. 2010-5108 (Fed. Cir. Apr. 16, 2010).

²⁹ 499 U.S. 554 (1991).

³⁰See, e.g., The American Worker, State and Business Relief Act of 2010, H.R. 4213, 111th Cong. § 421; The Heartland, Habitat, Harvest, and Horticulture Act of 2007, S. 2242, 110th Cong. §§ 511, 512, 513 (the "2007 Proposal"); The Telephone Excise Repeal and Taxpayer Protection and Assistance Act of 2006, S. 1321, 109th Cong. §§ 801, 802 (the "2006 Proposal"); The CARE Act of 2003, S. 476, 108th Cong. §§ 701, 704, 717; The Jobs and Growth Reconciliation Tax Act of 2003, H.R. 2046, 108th Cong. §§ 311, 314, 327 (together with the codification proposal from the CARE Act of 2003, the "2003 Proposal"); The Abusive Tax Shelter Shutdown Act of 1999, H.R. 2255, 106th Cong. (the "2000 Proposal"). For a comprehensive list of recent codification proposals, see Monte A. Jackel, Dawn of a New Era: Congress Codifies Economic Substance, 127 TAX NOTES 289, 289-90 n.3 (Apr. 19, 2010).

³¹ We use the phrase conjunctive from the perspective of what the taxpayer needs to establish to prevail against an ESD-based attack.

³² Many observers have suspected that recent codification proposals, including the version ultimately enacted under the Reconciliation Act, have been promoted, at least in part, because of their revenue-raising, or budget-scoring, potential. However, according to the estimates of the Joint Committee on Taxation (the "Joint Committee"), the potential revenue effects of codifying the ESD have decreased considerably over the past several years. For instance, the Joint Committee estimated that the 2006 Proposal, in tandem with associated penalties, would raise more than $17 billion in revenue for the government during the ten-year period following its enactment. See JCX-29-06 (June 28, 2006). By contrast, the Joint Committee's recent estimate of the revenue effects of Section 7701(o) and amended Section 6662 projects an increase of only $4.5 billion over the next decade. See JCX-17-10 (Mar. 20, 2010).

³³ H.R. Rep. No. 111-443. There is some question as to whether the House Report is technically an official part of the Reconciliation Act's legislative history and whether, in fact, Section 7701(o) has "official" legislative history. The House Report is based on the explanation of the ESD codification proposal provided by the House Ways and Means Committee on October 14, 2009. The House Ways and Means Committee explanation, however, was prepared for H.R. 3200, which contained provisions that ultimately were not included in Section 7701(o) -- these provisions included eliminating a reasonable-cause exception to penalties for "specified persons" and provided for a strict-liability penalty for tax shelters. After H.R. 3200, there were three more versions of proposed codification of the ESD before the Reconciliation Act: (i) H.R. 3962 (the Affordable Health Care for America Act that passed the House of Representatives on November 7, 2009), which made some technical changes to H.R. 3200, (ii) a version in the January 2010 efforts to meld H.R. 3962 with H.R. 3590 (passed by the Senate on December 24, 2009), which dropped the "specified persons" provision and the tax shelter-related penalty, among other changes and (iii) H.R. 4213, the Tax Extenders Act of 2009, which was passed by the Senate in March of 2010. Finally, the House of Representatives Rules Committee wrote what became the Reconciliation Act as an amendment in the nature of a substitute to H.R. 4872, and there was no new House (or Senate) report. The Joint Committee's technical explanation of the new provisions, JCX-18-10 (Mar. 21, 2010) (the "Joint Committee Report"), on the other hand, was prepared to explain the Reconciliation Act provision. Unlike a House Report, the Joint Committee Report is, however, not considered to be an official part of a law's legislative history. See, e.g., Hutchinson v. Comm'r, 765 F.2d 665, 669-70 (7th Cir. 1985) (noting that, while Joint Committee explanations do not "rise to the level of legislative history, because [they are] authored by Congressional staff and not by Congress . . . such explanations are highly indicative of what Congress did, in fact, intend"). In the case of the Joint Committee Report, however, because it was released four days before either chamber of Congress voted on the Reconciliation Act in its final form (and nine days before the President signed the legislation into law), and is the only piece of Congressional explanation with respect to the actual legislation that was enacted, it should be viewed as carrying relatively more authoritative weight than a Joint Committee explanation not prepared and published substantially contemporaneously with the passage of the subject legislation. See, e.g., Robinson v. Comm'r, 119 T.C. 44, 73 (2002) (observing that, because a Joint Committee staff summary "was provided to the Members of the House and Senate for their reference before Congress enacted TRA 1986 . . . consequently it is part of the history of the legislation").

³⁴ H.R. Rep. No. 111-443, at 293 & nn.109-112 (2010).

³⁵Id. at 295.

³⁶ H.R. Rep. No. 111-443, at 298; JCX-18-10, at 155 (emphasis added).

³⁷E.g., S. 1321, 109th Cong. § 801. As explained by the Joint Committee staff in a report accompanying President Obama's fiscal year 2010 budget proposal, in each of the nine economic substance codification bills that passed the Senate in the 108th and 109th Congresses, relying upon profit potential, the taxpayer's reasonably expected profit from the transaction was required to exceed a "risk-free" rate of return. JCS 3-09, at 53 n.150 (Sept. 2009).

³⁸Cf. Consol. Edison Co. of N.Y., Inc. v. United States, 90 Fed. Cl. 228, 326-30 (2009). Although the court in Consolidated Edison noted that the taxpayer's 4.44% pre-tax yield "is above the amount cases have previously acknowledged as sufficient pretax profit," id. at 326, it ruled that the leasing transaction in that case satisfied the ESD based in part on the presence of other tax-independent factors. Id. at 340-41. Similarly, as discussed in section III(E)(5)(e) in the text below, some transactions with a 2-4% pre-tax IRR could potentially be considered demonstrating sufficient profit under the statutory profit test, provided that the taxpayer's investment is truly at risk.

³⁹ 84 T.C. 412, 440 n.52 (1985). See the discussion in Section II.A, supra.

⁴⁰See discussion supra at note 33.

⁴¹ In both the House and Joint Committee Reports, H.R. Rep. No. 111-443, at 294, n.117; JCX-18-10, at 145, n.311, the text references the following footnote:

⁴⁴ H.R. Rep. No. 111-443, at 298 (footnotes omitted); JCX-18-10, at 154-55 (footnotes omitted).

⁴⁵ H.R. Rep. No. 111-443, at 298 n.137.

⁴⁶ JCX-18-10, at 155 n.356.

⁴⁷ 91 Fed. Cl. 35 (2010), appeal docketed, No. 2010-5108 (Fed. Cir. Apr. 16, 2010).

⁴⁸See Wells Fargo, 91 Fed. Cl. at 83 ("Wells Fargo's cost of funds alone turns the SILOs into a losing proposition. . . . [A]side from the net present value analysis and the lengthy deferral of payments . . . there was no reasonable possibility of profit from the SILOs simply because the expected non-tax investment return was less than Wells Fargo's cost of funds.").

⁴⁹ No matter what view is adopted, other aspects of the dispute in Wells Fargo, such as what present value and what rates to apply, remain. See note 118, infra.

⁵⁰See JCX-18-10, at 145 & n.311; H.R. Rep. No. 111-443, at 294 & n.117. These cases are more specifically described in the text as concluding "that the economic risks and profit potential were insignificant when compared to the tax benefits." Id.

⁵¹ JCX-18-10, at 155 n.356 (emphasis added). But see note 52 infra.

⁵² Although the cases cited in footnote 356 of the Joint Committee Report include three of the cases cited in footnote 312, which the Report stated supports merely nominal pre-tax profit, as compared to tax benefits, footnote 356 contains a parenthetical explanation of IES Industries whereas footnote 312 does not. This parenthetical explains that this case stands for the proposition that "the application of the objective economic substance test involves determining whether there was a 'reasonable possibility of profit . . . apart from tax benefits.'" JCX-18-10, at 155 n.356. This proposition differs from, and is not necessarily inferred by, the proposition drawn from the four cases in the text at footnote 312, that "it may be sufficient if there is a nominal amount of pre-tax profit as measured against expected tax benefits." JCX-18-10, at 145 & n.312. Accordingly, footnote 356 may be intended only to clarify the concept of reasonable expectation in the statutory formulation.

⁵³ It is worth noting that this phrase is taken from the House Report, H.R. Rep. No. 111-443, at 296 n.124; the JCT Report does not use the adverb "clearly." See note 93, infra.

⁵⁴ Again, to be clear, if the taxpayer is confident (contrary to our base-case assumption about what constitutes a mixed-motive transaction) that the ESD is in fact not "relevant" to her transaction, or if special rules are promulgated for that type of transaction that are designed to make the Profit Potential Test easier to satisfy because, for example, Treasury and the IRS determine that, although not exactly exempt from the ESD, the transaction is of the sort that Congress intended to encourage, provided that it had some minimum profitability or other positive indicia, then the transaction can survive, post-enactment of Section 7701(o).

⁵⁵ Since 1975, the IRS has published detailed guidelines that taxpayers must follow to obtain a private ruling respecting leveraged lease transactions. Rev. Proc. 2001-28, 2001-19 I.R.B. 1156, modifying and superseding Rev. Proc. 75-21, 1975-1 C.B. 715. Similarly, since 2007, the IRS has maintained and expanded guidelines that a wind energy flip partnership claiming production tax credits must follow in order for its tax allocations to be respected on audit. Rev. Proc. 2007-65, 2007-45 I.R.B. 1, modified by Ann. 2009-69, 2009-40 I.R.B. 475.

⁵⁶ H.R. Rep. No. 111-433, at 296; JCX-18-10 at 153.

⁵⁷See Johnson v. United States, 11 Cl. Ct. 17, 26-27 (1986) (explaining that Rev. Proc. 75-21 sets forth a minimal "level of profit motivation" that does not require a "dominant profit motive").

⁵⁸ Post-Trial Reply Memorandum for Defendant at 37, Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (2010), appeal docketed, No. 2010-5108 (Fed. Cir., Apr. 16, 2010); Memorandum for Defendant in Opposition to Post-Trial Motions at 24, Altria Group, Inc. v. United States, 694 F. Supp. 2d 259, 285 (S.D.N.Y. 2010) (No. 06 Civ. 9430).

⁵⁹See Treas. Reg. § 1.704-1(b)(1)(iii) ("[A]n allocation of loss or deduction to a partner that is respected under section 704(b) and this paragraph may not be deductible by such partner if the partner lacks the requisite motive for economic gain (see, e.g., Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966)). . . .").

⁶⁰ For example the leasing guidelines do not permit fixed-price lessee purchase options and the wind energy guidance does not apply to other types of renewable energy transactions or to transactions that utilize investment tax credits (or Treasury cash grants), rather than production tax credits.

⁶¹See Consol. Edison v. United States, 90 Fed. Cl. 228, 326 (2009) (government's leasing experts testified that pre-tax IRRs "between 2% and 4%" are common); AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 980 (N.D. Ohio 2008) (banks "typically receive . . . between 2.5% and 3.5% on their leveraged lease transactions"). It is our understanding that tax equity investments in renewable energy flip partnership transactions are generally structured to have a 2-3% pre-tax IRR, taking any tax credits (or Treasury cash grants) into account as a cash equivalent. Although the court in AWG Leasing ruled in favor of the taxpayer on ESD grounds, it ruled against the taxpayer on other substance over form principles. In Consolidated Edison, the court implied that the profit projected by the taxpayer was sufficient for ESD purposes, but it also identified other tax-independent purposes that supported its decision. 90 Fed. Cl. at 340-41.

⁶²See, e.g., Comm'r v. Acker, 361 U.S. 87, 91 (1959) ("We are here concerned with a taxing act which imposes a penalty. The law is settled that 'penal statutes are to be construed strictly,' [Fed. Commc'ns Comm'n v. Am. Broad. Co., 347 U.S. 284, 296], and that one 'is not to be subject to a penalty unless the words of the statute plainly impose it,' [Keppel v. Tiffin Sav. Bank, 197 U.S. 356, 362]. See, e.g., [Tiffany v. Nat'l Bank of Mo., 18 Wall. 409, 410; Elliott v. R.R. Co., 99 U.S. 573, 576].").

⁶³ Section 7701(o)(5)(A).

⁶⁴ H.R. Rep. No. 111-443, at 297 n.134 (emphasis added). JCX-18-10, at 154 n.353.

⁶⁵ H.R. Rep. No. 111-443, at 298. Previous codification proposals would have included this proviso in the statute itself. See, e.g., H.R. 2046, 108th Cong. § 311.

⁶⁶See H.R. Rep. No. 111-442, at 296; JCX-18-10, at 152.

⁶⁷See H.R. Rep. No. 111-443, at 292 ("These common-law doctrines are not entirely distinguishable, and their application to a given set of facts is often blurred by the courts, the IRS, and litigants."); JCX-18-10, at 142 (same).

⁶⁸See, e.g., Comm'r v. Court Holding Co., 324 U.S. 331 (1945) (applying substance-over-form principles in reordering the steps of a transaction formally structured as an asset sale followed by a tax-free corporate liquidation; no economic substance analysis); McDonald's Rests. of Ill., Inc. v. Comm'r, 688 F.2d 520 (7th Cir. 1982) (applying the step transaction doctrine, in a case that predated Treas. Reg. Section 1.368-1(e), to find that post-merger sales of stock caused a merger to fail the Section 368(a) "continuity of interest" requirement; no economic substance analysis); Tribune Co. v. Comm'r, 125 T.C. 110 (2005) (applying substance-over-form principles in characterizing the disposition of a corporation's subsidiary, which had been formally structured to meet the literal requirements of Section 368(a)(1)(A) and (a)(2)(E), as a taxable sale; no economic substance analysis); Martin Ice Cream Co. v. Comm'r, 110 T.C. 189 (1998) (applying substance-over-form principles to find that a corporation's 51 percent shareholder, not the corporation itself, was taxable on gain from the sale of ice cream distribution rights; no economic substance analysis); Intermountain Lumber Co. v. Comm'r, 65 T.C. 1025 (1976) (applying the "binding commitment" test to find a lack of Section 368(c) "control" with respect to a purported Section 351 exchange; no economic substance analysis); King Enters., Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (applying the step transaction doctrine in analyzing the acquisition of a target corporation's stock in exchange for a mix of stock and non-stock considerations, together with a subsequent merger of the target corporation with and into the acquiring corporation, as a "unified transaction" that qualified as a "Type A" reorganization; no economic substance analysis); Rev. Rul. 70-140, 1970-1 C.B. 73 (applying step-transaction principles in ruling that the incorporation of a sole proprietorship did not qualify as a Section 351 exchange because of a subsequent prearranged sale of the newly formed corporation's stock to a third party; no economic substance analysis); Rev. Rul. 67-448, 1967-2 C.B. 144 (applying step-transaction principles in ruling that the merger of a transitory subsidiary with and into a target corporation may qualify as a "Type B" reorganization if the "solely for voting stock" requirement is met; no economic substance analysis).

⁶⁹ Tax Ct. Rep. (CCH) 58,298 2010 WL 3064428 (2010).

⁷⁰ 2010 WL 3064428, at *8. Although there may be debate about the accuracy and legitimacy of the court's analysis in Canal Corp., there can be no debate about whether the court used the ESD to reach its decision. It did not cite any ESD cases and did not engage in any ESD analysis. Granted, the court did want to understand whether the indemnification agreement in question had any "economic substance," but that is a typical and normal inquiry as part of determining whether or not the purported indemnitor was to be allocated a share of the partnership's liabilities under Section 752. Having determined that the indemnity "created no more than a remote possibility that [the indemnitor] would actually be liable for payment," it was quick work for the court to determine that the indemnitor "should not be allocated any part of the debt." Id. at *12.

⁷¹See, e.g., United States v. Caruth, 699 F.2d 1017 (9th Cir. 1983).

⁷² H.R. Rep. No. 111-443, at 305.

⁷³Id. at 304.

⁷⁴But see The Growing Our Manufacturing Employment Act of 2004, S. 2155, 108th Cong. § 301 (2004) (no penalty provisions); The Dayton Fair Tax Cut Act of 2003, S. 135, 108th Cong. § 411 (2003) ("A disallowance is [subject to the penalty] if such disallowance is on account of . . . a lack of economic substance (within the meaning of section 7701(n)(1)) for the transaction giving rise to the claimed benefit . . . a lack of business purpose for such transaction or because the form of the transaction does not reflect its substance, or . . . a failure to meet the requirements of any similar rule of law.").

⁷⁵ H.R. Rep. No. 111-443, at 304.

⁷⁶ § 6664(c)(2).

⁷⁷ § 6676(c).

⁷⁸ H.R. Rep. No. 111-443, at 304 n.161.

⁷⁹ JCX-18-10, at 155 n.359.

⁸⁰See JCX-47-03, at 110 ("For this purpose, a similar rule of law would include, for example, an understatement attributable to a transaction that is determined to be a sham transaction.").

⁸¹ To be sure, the failure of a court to recite talismanic phrases should not prevent the application of Section 6662(b)(6) if the substance of the analysis focuses on the core questions of the ESD -- i.e., whether there is sufficient economic effect and a sufficient non-tax purpose for the transaction.

⁸² Section 6662(i)(1). At least structurally, this approach differs from most previous codification proposals, which would have made 40 percent the default rate and decreased it to 20 percent only if the taxpayer complied with the applicable disclosure requirements. Section 6662(i) flips the burden of inertia in the taxpayer's favor.

⁸³ Section 6662(i)(2). For these purposes, except as provided in Treasury Regulations, an amended tax return (or a supplement to a tax return) will not be taken into account if filed after the taxpayer has been contacted for audit (or such other date as is specified by Treasury). See Section 6662(i)(3); H.R. Rep. No. 111-443, at 304.

⁸⁴ By contrast, and uniquely, the 2000 Proposal included a number of detailed statutory rules with respect to the adequacy of such disclosure. Specifically, the taxpayer would have been required to disclose to the IRS "appropriate documents describing the transaction" within 30 days after closing, as well as submit various materials with the its tax return, including "a detailed description of the facts, assumptions of facts, and factual conclusions with respect to the business or economic purposes or objectives of the transaction that are relied upon to support the manner in which it is reported on the return." H.R. 2255, 106th Cong. § 4 (2000).

⁸⁵ Section 6662(d)(2)(B)(ii)(I) provides that, for purposes of the substantial understatement penalty under Section 6662(b)(2), the amount of an understatement is reduced by any portion of the understatement attributable to any item if "the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return," so long as there is a reasonable basis for the taxpayer's treatment of the item.

⁸⁶ S. Rep. No. 110-206, at 100-101 (2007).

⁸⁷See, e.g., S. 1321, 109th Cong. § 802 (2005-06) ("If the 1st letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals has been sent with respect to a penalty to which this section applies, only the Commissioner of Internal Revenue may compromise all or any portion of such penalty."); S. 2210, 108th Cong. § 303 (2003-04) ("The exercise [of the Commissioner's authority to compromise the penalty] shall be at the sole discretion of the Commissioner and may be delegated only to the head of the Office of Tax Shelter Analysis. The Commissioner, in the Commissioner's sole discretion, may establish a procedure to determine if a penalty should be referred to the Commissioner or the head of such Office for a determination [as to a potential compromise]. . . . Notwithstanding any other provision of law, any determination [as to a potential compromise] may not be reviewed in any administrative or judicial proceeding.").

⁸⁸ Notice 2010-62.

⁸⁹ 2010-7 I.R.B. 404.

⁹⁰ S. 2242, 110th Cong. § 511; see also S. 1321, 109th Cong. § 801 (similar language).

⁹¹ Section 7701(o)(5)(C).

⁹² H.R. Rep. No. 111-443, at 295-96; see also JCX-18-10, at 152.

⁹³Id. at 296 n.124 (citing Treas. Reg. § 1.269-2). This language differs from the corresponding footnote in the Joint Committee Report: "If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed . . . . Thus, for example, it is not intended that a tax credit . . . be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage." JCX-18-10, at 152 n.344.

⁹⁴ H.R. Rep. No. 111-443, at 296 (citations omitted); see also JCX-18-10, at 153.

⁹⁵ H.R. Rep. No. 111-443, at 296 n.125; see also JCX-18-10, at 152 n.345.

⁹⁶ Previous codification proposals would have specifically authorized Treasury to issue exemptions from the Codified ESD Test. See, e.g., S. 1321, 109th Cong. § 801 ("The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection. Such regulations may include exemptions from the application of this subsection." (emphasis added)).

⁹⁷ The examples from the 2003 Report are attached hereto as Appendix 1. We believe that the examples continue to be transactions to which the ESD is not "relevant" within the meaning of Section 7701(o).

⁹⁸See Robert Cassanos, Economic Substance, Business Purpose, and Tax Elections, Tax Forum No. 578, at 5 (Nov. 1, 2004) ("By definition, tax elections are tax-motivated. They have no business purpose. They have no economic substance. Therefore, a tax election should never be tested against a 'purpose' or 'substance' standard. The existence of a tax election is, in practice, a declaration by the taxing authority that it has little or no stake in the tax characterization of the transaction or entity in question, so it is in effect formally or informally delegating the choice of that characterization to the taxpayer.").

⁹⁹ For example, if a taxpayer were to form an entity that is a per se corporation under Reg. Section 301.7701-2 and then decide to convert it under state law to an LLC where it would default to status as a disregarded entity, that process should not be treated any differently than if the taxpayer had formed an LLC, initially elected to have it be treated as a corporation and later elected to have it treated as a disregarded entity under Reg. Section 301.7701-3. The first change is accomplished by means of an affirmative act and a default classification and obviously would require more "effort" than the second which is simply two tax elections and has some non-tax consequences. Nonetheless, analytically, both are equivalent for federal income tax purpose and one should not be favored over the other. Hence, they should be judged by the same standards.

¹⁰⁰See Section 7701(o)(1)(A).

¹⁰¹See Section 7701(o)(1)(B). Section 7701(o) contains a few miscellaneous rules that supplement Section 7701(o)(1) and govern whether certain specific items are taken into account for purposes of the Codified ESD Test. These provisions include Section 7701(o)(2), discussed below, which governs when a transaction's profit potential may be taken into account under the Codified ESD Test; see also Section 7701(o)(4) (providing that, for purposes of the Substantial Purpose Test, achieving a financial accounting benefit will not be treated as a purpose for entering into a transaction if the financial accounting benefit originates from a reduction of federal income tax); Section 7701(o)(3) (providing that, for purposes of both prongs of the Codified ESD Test, any state or local income tax effect that is "related" to a federal income tax effect will be treated in the same manner as the latter).

¹⁰² H.R. Rep. No. 111-443, at 297; see also JCX-18-10, at 153-54.

¹⁰³ The Second Circuit used this approach in Goldstein. As the court said in its conclusion:

¹⁰⁴ H.R. Rep. No. 111-443, at 293 n.112.

¹⁰⁵See, e.g., Yosha v. Comm'r, 861 F.2d 494, 497 (7th Cir. 1988). See also Zmuda v. Comm'r, 731 F.2d 1417, 1421 (9th Cir. 1984) ("[T]he Commissioner may deny legal effect to a transaction if its sole purpose is to evade taxation."); ASA Investerings P'ship v. Comm'r, 201 F3d 505, 513 (D.C. Cir. 2000) (same) (citing Zmuda).

¹⁰⁶ Section 7701(o)(2)(A).

¹⁰⁷See generally Smith, supra note 16, at 1, 4, 22. This approach, however, arguably was ignored (or rejected without comment) in the decision in Altria Group v. United States, 694 F. Supp. 259 (S.D.N.Y. 2010), where a district court permitted a jury to take the taxpayer's cost of funds into account in finding that the taxpayer was motivated solely by tax avoidance when it entered into LILO and SILO transactions that had an expected pre-tax rate of return that was lower than such cost of funds. Id. at 285 ("[T]he factfinder might conclude from the fact that a transaction is cashflow negative on a pretax basis that the tax avoidance was the primary, perhaps the only, factor motivating the transaction.").

¹⁰⁸ 435 U.S. 561 (1978).

¹⁰⁹Id. at 583-84. By definition, the Mixed-Motive Principle historically has, in general, allowed taxpayers to enter into transactions that would not be attractive "but for" the availability of tax benefits. As the Supreme Court stated in Frank Lyon, "[t]he fact that favorable tax consequences were taken into account by [taxpayer] Lyon on entering into the transaction is no reason for disallowing those consequences." Id. at 580.

¹¹⁰See generally Alvin C. Warren, The Requirement of Economic Profit in Tax Motivated Transactions, 59 TAXES 985, 987 (1981). To establish this point, Professor Warren reasoned, "[the requirement of a full market, pre-tax return] is logically incoherent because it ignores the fact that capital markets will take preferential tax treatment into account in setting relative prices." Id. at 987. In investment transactions motivated by financial returns, moreover, a taxpayer's overall cost of funds rate will typically be less than its expected after-tax yield. If a profit must be substantial compared to tax benefits, then after allocating the cost of funds, the required profit could easily approximate or exceed a full market return.

¹¹¹ To illustrate the PV of Profit Approach, we can take a simplified example: assume an initial investment of $100 with no other cash flows other than an expected return of $117 at the end of year 5. This investment has an approximate IRR of 3.19% per annum. If the $17 of profit is discounted at 1.99%, which is 130% of the mid-term AFR (annual compounding) for December 2010, the present value is $15.40 (i.e., 17/(1.0199)⁵ ). If the $17 of profit is discounted at 6%, the PV is approximately $12.70 (i.e., 17/(1.06)⁵ ). Obviously, if one reduced the profit to charge for direct or indirect costs of capital, and if the costs so charged exceeded $17 (representing a cost of capital at the IRR of 3.19%), the undiscounted and discounted profits would both be negative.

¹¹² Using the same simplified cash flows as in the example supra at note 111, if the discount rate used to determine the PV of cash flows were less than 3.19%, the $117 of cash flow would have a PV of more than $100 and the transaction would have a net profit. However, if the discount rate was 3.19% or higher, then the $117 of cash flow would have a PV of $100 or less, there would be no net profit and the transaction would per se fail the Profit Potential Test. For example, using a 6% discount rate, the PV of the $117 cash flow is 117/(1.06),⁵ or $87.43, resulting in a pre-tax loss of 12.57.

¹¹³ Generally, as discussed in Section II(A) above, prior to the Third Circuit's decision in ACM Partnership, courts had declined to apply discount rates that reflected prevailing interest rates. For example, in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), the Ninth Circuit, in reversing the Tax Court, said (albeit without further analysis) that an investor is not "bound to discount the future at the rate the Commissioner thinks prudent." Id. at 991 (citing Hilton v. Comm'r, 671 F.2d 316 (9th Cir. 1982)). By both implication and practice, this restraint extended to the use of discount rates based on the taxpayer's allocable funding costs.

¹¹⁴ 909 F.2d 1360 (9th Cir. 1990).

¹¹⁵Id. at 1366.

¹¹⁶ 91 Fed. Cl. 35 (2010), appeal docketed, No. 2010-5108 (Fed. Cir. Apr. 16, 2010).

¹¹⁷See id. at 82 ("Wells Fargo's cost of funds alone turns the SILOs into a losing proposition. . . . [A]side from the net present value analysis and the lengthy deferral of payments . . . there was no reasonable possibility of profit from the SILOs simply because the expected non-tax investment return was less than Wells Fargo's cost of funds."); see also Altria Group, Inc. v. United States, 694 F. Supp. 2d 259, 284 (S.D.N.Y. 2010) (observing that, for purposes of measuring pre-tax profit potential, "[p]resent value analysis . . . seeks to determine whether an investment's expected returns exceeds [sic] the costs of pursuing the investment, including the investor's cost of capital").

¹¹⁸ A review of the record in the case and some of the briefs submitted by the parties indicates that the court in Wells Fargo was taking into account the taxpayer's cost of debt capital as if the investment was fully debt financed, without regard to how the taxpayer actually financed the investment. First, it is clear that in comparing the bank's anticipated pre-tax return to its "cost of funds for the leasing business," Wells Fargo, 91 Fed. Cl. at 82, the court was referring only to the leasing business's cost of debt capital, not its cost of debt and equity capital. Johnson Transcript at 1850-54, Wells Fargo, 91 Fed. Cl. 35 (No. 06-628T). Second, as evidence of that business's cost of debt capital, the court relied upon an internal bank document that the taxpayer's witness testified was used to price its desired yield spread over its cost of funds, Johnson Transcript at 1850-54, Wells Fargo, 91 Fed. Cl. 35 (No. 06-628T), and that those costs were assumed to be the bank's costs "of borrowing to directly match the maturity and repayment schedules of various loans." Defendant's Exhibit No. 526 at 1, Wells Fargo, 91 Fed. Cl. 35 (No. 06-628T). However the taxpayer's reply brief in the appeals case points out that the government's expert testified that he could find no evidence that any matched funding was ever implemented for the transaction. Reply Brief for Plaintiff-Appellant at 35-36, Wells Fargo v. U.S., No. 06-CV-628 (Fed. Cir. Aug. 23, 2010); Lys Transcript at 4583-84, Wells Fargo, 91 Fed. Cl. 35 (No. 06-628T).

¹¹⁹ Rev. Proc. 2001-28, 2001-19 I.R.B. 1156, § 4.06(1), superseding Rev. Proc. 75-21, 1975-1 C.B. 15.

¹²⁰ We fully recognize that Sections 246A and 265(a)(2) are not clear analogies to the "transaction cost" determination for the Profit Potential Test. Each of those Code sections includes, as part of their statutory language, general attribution principles (e.g., "directly attributable to" and "for the purpose of"), as well as exceptions for debt expenses related to non-"portfolio" investments.

¹²¹See, e.g., Rev. Rul. 88-66, 1988-2 CB 34. In Revenue Ruling 88-66, the IRS said (omitting citations):

¹²⁴ Treasury Reg. § 1.263A-9(a)(1).

¹²⁵ A similar result obtains if the discount rate (or the indirect costs) should also include the cost of equity (if calculable).

¹²⁶ § 7701(o)(2)(B).

¹²⁷ 277 F.3d 778 (5th Cir. 2001).

¹²⁸ 253 F.3d 350 (8th Cir. 2001).

¹²⁹ § 7701(o)(2)(B).

¹³⁰See, e.g., H.R. 3962, 111th Cong. § 562.

¹³¹ Notice 98-5, 1998-1 C.B. 324, contemplated that regulations would apply an economic profit test to disallow credits for foreign taxes generated in an arrangement such as those described above if the reasonably expected economic profit were determined to be insubstantial compared to the value of the foreign tax credits expected to be obtained as a result of the arrangement.

¹³² Notice 2004-19.

¹³³ That is, the "present value of . . . pre-tax profit" could be read to be essentially equivalent to "the pre-tax profit determined on a present value basis," i.e., by discounting cash flows. The "substantial" comparison would be made using such result.

¹³⁴See discussion supra at notes 117 & 118.

¹³⁵ H.R. Rep. No. 111-433, at 296; JCX-18-10, at 152-53.

¹³⁶ H.R. Rep. No. 111-433, at 296 n.130; JCX-18-10, at 153, n. 350.

¹³⁷ Frank Lyon Co. v. United States, 435 U.S. 561 (1978).

¹³⁸ Cases that suggest that Congress intended leasing transactions to have favorable treatment do not conclude that such transactions are exempt from the ESD, but rather that the ESD must be applied to them in a manner that does not conflict with Congressional intent. The leading case of this kind is Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), rev'g 64 T.C.M. (CCH) 1003 (1985). In Sacks, the Ninth Circuit rejected the Tax Court's use of a 17% per annum discount rate in concluding that an equity investment in solar energy equipment lacked economic substance. It reasoned that an investor is not "bound to discount the future at the rate the Commissioner thinks prudent," id. at 991, citing its prior opinion in Hilton v. Commissioner, 671 F.2d 316 (9th Cir. 1982). In addition, the Ninth Circuit observed that "[a]bsence of pre-tax profitability does not show 'whether the transaction had economic substance' . . . where Congress has purposely used tax incentives to change investors' conduct." 69 F.3d at 991 (citation omitted). However, the Ninth Circuit determined that the case was controlled by Frank Lyon and determined that, based on various indicia of substance other than pre-tax profitability, the transaction had economic substance.

¹³⁹See, e.g., Codification of Economic Substance Doctrine Not a Change in Substantive Law, Says IRS, Daily Tax Report (BNA), Oct. 7, 2010 (193 DTR G-3).

¹⁴⁰ This approach would, however, diverge from the standard approach of traditional financial analysis.

¹⁴¹ H.R. Rep. No. 111-433, at 296 n.124; see also JCX-18-10, at 152 n.344.

¹⁴² To be clear, we do not think that it can be taken to mean "net cumulative tax benefit," because a transaction that takes advantage only of a tax timing benefit, such as accelerated depreciation, would generate a negative net present value in the Profit Potential Test's denominator, as a result of computationally deferring early period tax savings to match them up with subsequent taxes. The adjective "net" also does not imply or support adding "cumulative" to the statute, because "net" most commonly and naturally means tax benefits net of tax detriments over the period in question. Nor does the plural form, "net tax benefits," commonly mean "net cumulative tax benefit"; to the contrary, it most commonly means the set of net tax benefits generated over multiple periods.

¹⁴³ It would not be all that difficult, however, to establish a conservative approach for determining the times at which profit should be deemed realized. For example, a relatively conservative method for determining how much profit should be allocated to a positive pre-tax cash flow would be to compute a present value for the transaction's cash flows using a discount rate equal to the transaction's pre-tax IRR, and treat the excess of each such cash flow over its present value as "profit." Other methods that might treat profit as earned more rapidly could also be appropriate if consistent with the given transaction's economics.

¹⁴⁴ To promote fairness among different taxpayers and to implement policy with respect to transactions that utilize tax incentives, Treasury and the IRS should consider whether such taxpayers should be given an advantage in the application of the Profit Potential Test by allowing their low cost of funds to be used to discount pre-tax profit.

¹⁴⁵ The pre-tax rate is the expected investment yield divided by the result of one minus the then applicable tax rate.

¹⁴⁶ Under Section 382(f)(2), for instance, an adjusted federal long-term tax-exempt rate is computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds for bonds with remaining periods to maturity of more than nine years. See Rev. Rul. 86-133, 1986-2 C.B. 59; see also Section 1288(b) (requiring tax-exempt rates to be used to compute original issue discount on tax-exempt obligations under Sections 483 and 1274); Rev. Rul. 2010-24, 2010 I.R.B. LEXIS 6 (Table 2 specifies adjusted AFRs for purposes of Section 1288(b) for the month of October, 2010).

¹⁴⁷Cf. Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 545 (5th Cir. 2009) ("Various courts have held that when applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits." (citing Coltec Indus. v. United States, 454 F.3d 1340, 1356-57 (Fed Cir. 2006); Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284, (2d Cir. 2002))). Under the Codified ESD, a determination must be made as to whether the transaction constitutes a meaningful change of economic position. This raises the question, "As compared to what?" In many cases, such as the "built-in loss" transaction discussed in the text, the answer to the question may determine what the "net tax benefits" are for purposes of the Profit Potential Test. See generally David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 TAX LAW. 235, 236, 264 (1999). We observe that this question may not satisfactorily frame the issue we identify with respect to accelerated depreciation, however, particularly if the taxpayer does not have the choice to use a purely economic depreciation schedule.

¹⁴⁸See Treas. Reg. § 1.279-3(c)(2), defining "substantial" as 5% or more. See also Section 751(b)(3), defining "substantial" as 20% or more; Section 168(d)(3), defining "substantial" as 40% or more; Section 382(l), defining "substantial" as one third or more.

¹⁴⁹ As discussed above, the Profit Potential Test, for those transactions where the ESD is deemed "relevant," cannot avoid invalidating broad categories of such transactions previously considered legitimate, subject to the defense that the results are clearly intended by Congress, if: (i) all pre-tax cash flow must be discounted to present value using a market discount rate, instead of just (undiscounted) pre-tax profit or (ii) the taxpayer's indirect cost of funds must be taken into account in computing either undiscounted or discounted pre-tax profit. Hence, in our hypotheticals, we present valued gross, pre-tax profit and did not treat indirect cost of funds as an expense.

¹⁵⁰ JCX-18-10, at 152 n.344.

¹⁵¹But see, Friendship Dairies, Inc. v. Comm'r, 90 T.C. 1054, 1065 (1988), in which the Tax Court declined to treat the broad-based investment tax credit (which was available under prior law) as a reduction of the cost of the property on the grounds that the credit was not intended to be a subsidy but merely a substitute for a "capital investment deduction." By contrast, using the distinction drawn by the Tax Court, we believe that the energy investment tax credit under Section 48 is a subsidy that Congress intended to be used to "transform unprofitable transactions into profitable ones." 90 T.C. at 1065-66. The Joint Committee Report identifies other tax credits that serve a similar purpose, including those arising under Sections 42 (low-income housing credits), 45 (production tax credits), 45D (new markets tax credits) and 47 (rehabilitation credits). See also JCX-18-10, at 152 n.344.

¹⁵² We also note that it is far from clear whether Congress intended such transactions to be subject to the Codified ESD Test at all. See, e.g., Sacks v. Comm'r, 69 F.3d 982, 991 (9th Cir. 1995) ("Absence of pre-tax profitability does not show 'whether the transaction had economic substance beyond the creation of tax benefits,' where Congress has purposely used tax incentives to change investors' conduct." (quoting Casebeer v Comm'r, 909 F.2d 1360, 1365 (9th Cir. 1990))).

¹⁵³See generally David P. Hariton, The Frame Game: How Defining the 'Transaction' Decides the Case, 63 TAX LAW. 1 (2009).

¹⁵⁴ 454 F.3d 1340 (Fed. Cir. 2006). In Coltec, the taxpayer ("Coltec") was faced with potentially massive contingent liabilities stemming from asbestos litigation against Garlock (a subsidiary of Coltec) and Anchor (a subsidiary of Garlock). In a putative attempt to improve Coltec's liability position vis-à-vis the asbestos litigants, Garlock contributed all of the stock of Anchor, along with a $375 million promissory note issued by one of its other subsidiaries, to Garrison (a dormant subsidiary of Coltec). In exchange, Garrison issued shares of common stock to Garlock and assumed all liabilities incurred in connection with asbestos-related claims against Garlock. Garrison also concurrently assumed all management responsibilities with respect to such claims. When Garlock subsequently sold the Garrison stock to two banks for $500,000, Coltec's consolidated group reported a large loss on the sale. Coltec took the position that, under Section 357(c)(3), the assumption of Garlock's contingent liabilities by Garrison was excluded from the calculation of Garlock's basis in the Garrison stock. Analyzing Garrison's assumption of Garlock's contingent asbestos liabilities in isolation, the Federal Circuit ultimately upheld the disallowance of Coltec's loss on the grounds that the liability assumption lacked economic substance.

¹⁵⁵ H.R. Rep. No. 111-443, at 296-97 (citations omitted).

¹⁵⁶See, e.g., S. 1321, 109th Cong. § 801; H.R. 2046, 108th Cong. § 311; S. 476, 108th Cong. § 701; see also H.R. 2255, 106th Cong. § 3 ("In the case of any transaction which is an integral part of a taxpayer's trade or business and which is entered into in the normal course of such trade or business, the determination of the potential income from such transaction shall be made by taking into account its relationship to the overall trade or business of the taxpayer.").

¹⁵⁷ H.R. Rep. No. 111-443, at 297 n.135 (quoting Treas. Reg. § 1.269-2(b); ACM P'ship v. Comm'r, T.C. Memo. 1997-115, at 113).

¹⁵⁸ 102 A.F.T.R.2d (RIA) 2008-5085 (S.D. Tex. 2008).

¹⁵⁹ In Shell, the taxpayer ("Shell"), the parent of a consolidated group of financially distressed corporations, formed a new subsidiary, Frontier, as part of a new strategy to improve cash flows and investment returns. Frontier then issued (i) common stock and non-voting preferred stock to two of Shell's subsidiaries in exchange for certain "highly productive" assets; (ii) 900 shares of voting "auction preferred stock" to Western, one of Shell's "old and cold" subsidiaries, in exchange for certain "non-producing," high-basis assets; and (iii) 1100 shares of voting auction preferred stock to unrelated investors in exchange for cash (collectively, the "Frontier Exchange"). Shell took the position that, because the Frontier Exchange was an exchange described in Section 351, Western's basis in the non-voting auction preferred stock was determined by reference to the non-producing assets under Section 358. As a result, Shell argued, Shell's consolidated group recognized a large loss on Western's subsequent sale of that stock. The IRS disallowed the loss, arguing that the non-producing assets, which had zero discounted net cash-flow value, did not constitute "property" for purposes of Section 351(a), and that the Frontier Exchange flunked the ESD. The court ultimately rejected both of these arguments and sustained the taxpayer's position.

¹⁶⁰See discussion supra note 155.