CODIFICATION OF ECONOMIC SUBSTANCE DOCTRINE AND PENALTIES.

SEC. 1409. CODIFICATION OF ECONOMIC SUBSTANCE DOCTRINE AND PENALTIES. (a) [26 U.S.C. 7701] In General.—Section 7701 of the Internal Revenue Code of 1986 is amended by redesignating subsection (o) as subsection (p) and by inserting after subsection (n) the following new subsection: “(o) Clarification of Economic Substance Doctrine.— “(1) Application of doctrine.—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. “(2) Special rule where taxpayer relies on profit potential.— “(A) In general.—The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction 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. “(B) Treatment of fees and foreign taxes.—Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. “(3) State and local tax benefits.—For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect. “(4) Financial accounting benefits.—For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax. “(5) Definitions and special rules.—For purposes of this subsection— “(A) Economic substance doctrine.—The term ‘economic substance doctrine’ means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. “(B) Exception for personal transactions of individuals.—In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. “(C) Determination of application of doctrine not affected.—The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted. “(D) Transaction.—The term ‘transaction’ includes a series of transactions.” . (b) Penalty for Underpayments Attributable to Transactions Lacking Economic Substance.— (1) [26 U.S.C. 6662] In general.—Subsection (b) of section 6662 is amended by inserting after paragraph (5) the following new paragraph: “(6) Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.” . (2) Increased penalty for nondisclosed transactions.—Section 6662 is amended by adding at the end the following new subsection: “(i) Increase in Penalty in Case of Nondisclosed Noneconomic Substance Transactions.— “(1) In general.—In the case of any portion of an underpayment which is attributable to one or more nondisclosed noneconomic substance transactions, subsection (a) shall be applied with respect to such portion by substituting ‘40 percent’ for ‘20 percent’. “(2) Nondisclosed noneconomic substance transactions.—For purposes of this subsection, the term ‘nondisclosed noneconomic substance transaction’ means any portion of a transaction described in subsection (b)(6) 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. “(3) Special rule for amended returns.—In no event shall any amendment or supplement to a return of tax be taken into account for purposes of this subsection if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the Secretary regarding the examination of the return or such other date as is specified by the Secretary.” . (3) [26 U.S.C. 6662A] Conforming amendment.—Subparagraph (B) of section 6662A(e)(2) is amended— (A) by striking “section 6662(h)” and inserting “subsections (h) or (i) of section 6662”; and (B) by striking “gross valuation misstatement penalty” in the heading and inserting “certain increased underpayment penalties”. (c) Reasonable Cause Exception Not Applicable to Noneconomic Substance Transactions.— (1) [26 U.S.C. 6664] Reasonable cause exception for underpayments.—Subsection (c) of section 6664 is amended— (A) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; (B) by striking “paragraph (2)” in paragraph (4)(A), as so redesignated, and inserting “paragraph (3)”; and (C) by inserting after paragraph (1) the following new paragraph: “(2) Exception.—Paragraph (1) shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6).” . (2) Reasonable cause exception for reportable transaction understatements.—Subsection (d) of section 6664 is amended— (A) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively; (B) by striking “paragraph (2)(C)” in paragraph (4), as so redesignated, and inserting “paragraph (3)(C)”; and (C) by inserting after paragraph (1) the following new paragraph: “(2) Exception.—Paragraph (1) shall not apply to any portion of a reportable transaction understatement which is attributable to one or more transactions described in section 6662(b)(6).” . (d) [26 U.S.C. 6676] Application of Penalty for Erroneous Claim for Refund or Credit to Noneconomic Substance Transactions.—Section 6676 is amended by redesignating subsection (c) as subsection (d) and inserting after subsection (b) the following new subsection: “(c) Noneconomic Substance Transactions Treated as Lacking Reasonable Basis.—For purposes of this section, any excessive amount which is attributable to any transaction described in section 6662(b)(6) shall not be treated as having a reasonable basis.” . (e) [26 U.S.C. 6662 note] Effective Date.— (1) In general.—Except as otherwise provided in this subsection, the amendments made by this section shall apply to transactions entered into after the date of the enactment of this Act. (2) Underpayments.—The amendments made by subsections (b) and (c)(1) shall apply to underpayments attributable to transactions entered into after the date of the enactment of this Act. (3) Understatements.—The amendments made by subsection (c)(2) shall apply to understatements attributable to transactions entered into after the date of the enactment of this Act. (4) Refunds and credits.—The amendment made by subsection (d) shall apply to refunds and credits attributable to transactions entered into after the date of the enactment of this Act.