The health care bill’s opponents said it would cause a massive budget gap. But one element of it is expected to raise some $4.5 billion over the next 10 years. This is an issue that’s of crucial importance to treasurers, since it narrows the parameters of “economic substance” for transactions and establishes the penalties for failing to meet the tests for these transactions.
Specifically, as Peter Connors of Orrick, Herrington & Sutcliffe, notes, there’s now a two-pronged test:
1) That the transaction change the taxpayer’s economic position (the objective prong); and
2) That the taxpayer have a legitimate non-tax business purpose for entering into the transaction (the subjective prong).
The parameters for “economic substance” transactions are getting a little narrower. — Orrick, Herrington & Sutcliffe
The transaction is now seen as having “economic substance” if it:
1) Changes in a meaningful way (apart Federal income tax) the taxpayer’s economic position and;
2) The taxpayer has substantial purpose (other than tax) for entering into the transaction.
Transactions that don’t meet the economic doctrine test will attract 20 percent of the amount of underpayment. If a transaction is not disclosed, the penalty is 40 percent. This cannot be avoided by an amended return, for example, after the company has been contacted for an audit, according to Orrick. There will be many questions as to what transactions need to be tested under the new legislation.
Meanwhile…
As of mid- March, the tax code has treated equity derivatives in the same manner as notional or cash contracts. So, for example, when the law becomes effective in September, total return swaps and contracts for differences involving U.S. equities are now subject to withholding tax. This is part of the backlash against withholding tax avoidance schemes that have been employed over the years. Treasurers should expect changes in the ISDA master agreement on withholding risk.
Timely Dividends
Corporate treasurers are considering special dividends rather than payout increases, especially given the move toward potentially higher taxes. Members of the Tech20 Treasurers’ Peer Group decided that, on balance, firms should forgo dividend increases and make a special payout instead before the Bush tax cuts expire and the health-care set-offs kick in.
If the Bush tax cuts expire, dividend taxes will move from 15 percent to 43.4 percent the top tax rate includes a new 3.8 percent Medicare tax on unearned income levied by the Health Care Reform law.