Economic substance is a term for a “doctrine” initially created by courts. To curb tax shelters and/or sham schemes that serve no purpose other than tax avoidance, courts invoke the economic substance doctrine to deny deductions, credits and losses arising from these transactions.
What’s it mean? Under the economic substance doctrine, when you enter into a transaction merely to reduce your federal tax bill and no other meaningful economic change occurs, any tax benefits you claim on your return can be denied. That’s true even if you meet all the requirements in the Internal Revenue code that would apply to the transaction.
Economic substance was not part of the tax code until the Health Care and Education Affordability Reconciliation Act of 2010. This law created a new Internal Revenue code section (7701(o)), which provides that–
“In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if–
(A) the transaction 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 such transaction.”
The new law applies to transactions occurring after March 30, 2010.