The Tax Surprises in Healthcare Reform

Tax executives are getting up to speed on the tax implications of healthcare reform, including a subtle but significant new provision that has little to do with healthcare directly.

The provision is Section 1409 of the Health Care and Education Affordability Reconciliation Act. Essentially, it takes a concept developed and applied sporadically in case law—the “economic substance doctrine,” which says transactions must have a business purpose beyond simply getting a tax benefit to pass regulatory scrutiny—and makes it a permanent feature of the Internal Revenue Code. Congress included Section 1409 as a way to raise revenue for expanded healthcare services.

By codifying the economic substance doctrine, Congress is seeking to block any aggressive tax-planning strategies that companies might still be plotting or pursuing. Section 1409 is also likely to have a chilling effect on tax planning strategies, especially in these early days after the healthcare reform’s passage as the tax profession awaits guidance from the Internal Revenue Service about how the provision will work in practice.

Fontenot

“The No. 1 issue that companies are talking to us about is the uncertainty this creates, and the significant risk,” says Gray Fontenot, a tax partner with PricewaterhouseCoopers. “The immediate imperative is taxpayers are engaging in business transactions today, after the effective date, with uncertainty about how the IRS will determine whether this doctrine is relevant to the transaction and with no test for how economic substance will be interpreted or applied.”

The concept of economic substance has developed over many years through various court cases, Fontenot says. As refined by the appellate courts, the doctrine has come to mean that a transaction can only pass muster with tax authorities if it has some non-tax business purpose or if it creates a meaningful change in economic position for the taxpayer, beyond merely producing a tax break.

As codified in Section 1409, however, the doctrine no longer allows for that either-or analysis: A taxpayer must be able to show a transaction has both a non-tax business purpose and produces a meaningful change in economic position to stand up as legitimate, Fontenot says.

Even further, Congress laced the newly codified doctrine with some stiff consequences. Taxpayers could be subject to a 20 percent strict liability penalty if a transaction is disclosed but fails the economic substance test; the penalty rises to 40 percent if the transaction isn’t disclosed. “This is a significant penalty,” Fontenot says. Various outside groups estimate that the tax change will raise an additional $4.5 billion to $5 billion in revenue annually.

Gall

In a recent Deloitte & Touche Webcast on the new doctrine, Phillip Gall, a tax principal with the firm, described Section 1409 as the most significant tax change to come out of healthcare reform. Many taxpayers might decide not to proceed with a transaction even if they are confident it will pay scrutiny, he said. “Given the uncertainty, we hope guidance will be issued as soon as possible so as not to have this provision interfere inappropriately with legitimate transactions.”

“The IRS will eventually need to issue more guidance on specific provisions such as a new tax on Cadillac health plans, an increase in payroll taxes, the application of nondiscrimination rules to insured plans, and others.”

—Edward Leeds,

Of Counsel,

Ballard Spahr

In a poll during the Webcast (which was attended by some 1,800 tax professionals), 44 percent said they expected the new provision to have a significant effect on how transactions are evaluated; 35 percent expected the effect to be at least moderate. Irwin Panitch, another Deloitte tax principal, said taxpayers are likely to seek more advance rulings from the IRS. “That’s one thing that can take the risk of penalty completely off the table,” he said, “because if the IRS blesses it, that should be good.”

Panitch

Companies also are likely to have even more frank dialogue with auditors about where and how uncertainty over tax positions is reflected in financial statements, he said, and accounting officers are likely to have more face time with the boards and audit committees discussing tax risks.

And on top of all that, the new language on penalties makes no allowance for taxpayers simply following the advice of their tax professionals, Panitch warned. “Even though tax opinions don’t provide any protection from penalties, I think there’s going to be greater inclination to see something written up,” he said.

And a Few Other Points

Gibson

Aside from the economic substance doctrine, healthcare reform contains a long list of other tax provisions, intended to expand coverage for uninsured workers and their dependents, curb excesses for more highly compensated employees, and impose penalties where insurance is not offered. The new laws also establish several new reporting and documentation requirements.

ECONOMIC SUBSTANCE DOCTRINE

Below are some excerpts from a recent Deloitte Webcast on the economic substance doctrine:

On March 30, 2010, the President signed the Health Care and

Education Reconciliation Act of 2010. The Act added new section 7701(o), which “clarifies and enhances”

the application of the common law economic substance doctrine,

according to section 7701(o)’s primary legislative history, a March

21 pamphlet by the staff of the Joint Committee on Taxation (JCX-

18-10).

The JCT pamphlet states that new section 7701(o) does not change

prior law standards in determining when to utilize an economic

substance analysis.

New section 7701(o) defines the term “economic substance doctrine” to mean the common law doctrine under which tax benefits under Code sections 1 through 1563 with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a

business purpose.

Under new section 7701(o), in the case of any

transaction to which the economic substance doctrine is

relevant, a transaction is treated as having economic

substance only if: (a) It changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and (b) the taxpayer has a substantial purpose (apart from federal

income tax effects) for entering into the transaction.

The provision is effective for transactions entered into

after March 30, 2010.

Satisfying the two prongs of the economic

substance doctrine

A taxpayer may rely on profit potential to satisfy both prongs of the economic substance doctrine. However, 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.

—Fees and other transaction expenses are taken into account as expenses in

determining pre-tax profit.

—The Treasury is instructed to issue regulations requiring foreign taxes to be

treated as expenses in determining pre-tax profit “in appropriate cases.” The

JCT pamphlet states that there is no intention to restrict the ability of the

courts to consider the appropriate treatment of foreign taxes in particular

cases.

The JCT pamphlet states that a taxpayer may rely on factors other than

profit potential to demonstrate that a transaction results in a meaningful

change in the taxpayer’s economic position or that the taxpayer has a

substantial non-federal-income-tax purpose.

Any state or local income tax effect that is related to a

federal income tax effect is treated in the same manner

as a federal income tax effect.

Achieving a financial accounting benefit is not taken into

account as a non-federal tax purpose for entering into a

transaction if the origin of such financial accounting

benefit is a reduction of federal income tax.

Source

Deloitte Webcast Slides on Economic Substance (April 27, 2010)

Andy Gibson, a tax partner with accounting firm BDO, says companies are engaged in “a big debate” over how to comply with the new requirements. “If you don’t meet these new rules, you’ll have to pay an excise tax,” he says. “Companies will probably decide whether it may be cheaper just to pay the tax. That’s something that will play out over time, but the idea is floating out there.”

Waidmann

Anne Waidmann, a director in the human resources practice at PwC, says companies will try to strike a balance between offering benefits or paying penalties, and several years may pass before that balance is found. Corporate America is still waiting on a great deal of guidance, she says, and penalties for non-compliance “are not set in stone. The government can increase the penalties if employers elect not to offer coverage.”

Edward Leeds, a lawyer at the law firm Ballard Spahr, says critical guidance is yet to come from the IRS, the Treasury Department, and the Health and Human Services Department. (The IRS recently issued the first batch of healthcare reform guidance, on how to extend tax-favored health benefits to employees’ dependents through the age of 26.)

“The IRS will eventually need to issue more guidance on specific provisions such as a new tax on Cadillac health plans, an increase in payroll taxes, the application of non-discrimination rules to insured plans, and more,” Leeds says.

Costley

On the documentation front, companies will have new information to add to their W-2s, which report employees’ earnings and tax withholdings, says LeighAnn Costley, a principal with consulting firm UHY Advisors. Under the new rules, employers must include an aggregate cost for all their employer-sponsored benefits, she said. That’s not something that’s typically been reported.

Companies also will be issuing many more Form 1099s, where they report miscellaneous payments that might constitute income. Previously, companies had to provide 1099s only to individuals or partnerships; now they will have to provide them to corporations and other tax-exempt organizations as well, Costley says.