Codification of the Economic Substance Doctrine: Substantive Impact and Unintended Consequences

62 Pages Posted: 2 May 2018 Last revised: 23 Oct 2018

See all articles by Rebecca Rosenberg

Rebecca Rosenberg

Ohio Northern University, Pettit College of Law

Date Written: April 8, 2018


Section 7701(o) of the Internal Revenue Code of 1986 (the “Code”) imports the judicial doctrine of economic substance into statutory language (i.e., it “codifies” the doctrine). The economic substance doctrine provides that certain tax benefits can be denied if they go beyond congressional intent, even if all of the literal requirements of the Code and its regulations are met. The doctrine is perpetually controversial and has been the subject of recent litigation.

This article argues that codification changed the economic substance doctrine (rather than just copying it into statutory form) and produced unintended consequences, many of which have gone unnoticed. The article analyzes the language and structure of Section 7701(o) in order to explain its actual legal consequences and its substantive differences from previous case law.

The article argues that Section 7701(o) unintentionally changed the conjunctive test that it was trying to codify. The “conjunctive test” in the economic substance case law means that a transaction must meet both an objective test (focusing on economic effects) and a subjective test (focusing on the taxpayer’s intent or “business purpose”), not just one or the other. The structure of Section 7701(o), combined with rules of statutory interpretation, shows that these two prongs are now equal to each other, and that their content now cannot be identical. In the pre-codification case law, in contrast, the objective and subjective analyses often duplicated each other because both focused largely on reasonable expectation of profit. When the objective and subjective tests differed from each other, the objective prong was given greater emphasis. Section 7701(o) appears to have changed all of that for years to which it applies.

This article also explains several other changes that Section 7701(o) made to the economic substance doctrine. For example, objective economic change must now be “meaningful” and a subjective business purpose must now be “substantial” in order to meet the economic substance test. Both of these terms are undefined, but their plain meaning appears harsher than the previous case law standards. In addition, subjective intent is not required to be “reasonable,” which will lead to interesting questions about the treatment of sincere (but unreasonable) non-tax purposes.

There are also a series of issues which are notable for their absence in Section 7701(o). First, the statute specifically reserves to the courts the determination of which types of tax benefits and transactions are subject to an economic substance analysis and which are exempt. Notwithstanding this fact, many commentators have asked the IRS to issue guidance on which types of transactions are at risk of being analyzed under the doctrine. This article points out that the IRS simply does not have the authority to make these determinations.

Further, this article argues that the delineation of the tested transaction has not been changed by codification — the IRS and the courts have the same ability to define the tested transaction as they did before. This is a crucial issue that can determine the result of an economic substance analysis, causing a tax benefit to be allowed or disallowed.

No case has yet interpreted Section 7701(o). Given its enactment in 2010 and the time it takes for cases to reach the courts, however, this topic may be arriving in the courts at any time.

Keywords: Federal Tax, Economic Substance Doctrine, Section 7701(o)

JEL Classification: K34

Suggested Citation

Rosenberg, Rebecca, Codification of the Economic Substance Doctrine: Substantive Impact and Unintended Consequences (April 8, 2018). Hastings Business Law Journal, Vol. 14, Forthcoming. Available at SSRN:

Rebecca Rosenberg (Contact Author)

Ohio Northern University, Pettit College of Law ( email )

525 South Main Street
Ada, OH 45810
United States

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