LB&I instructs examiners on how to seek approval to apply economic substance doctrine

In a July 15th directive from IRS's Large Business & International (LB&I) Division, IRS issued guidance for managers and examiners on determining when to seek the approval of the Director of Field Operations (DFO) in order to raise the economic substance doctrine. The directive lays out a multi-step analysis for examiners to complete before submitting their requests to the DFO.

Background on economic substance. For transactions entered into after Mar. 30, 2010, and for underpayments, understatements, and refunds and credits attributable to transactions entered into after Mar. 30, 2010, a transaction to which the economic substance doctrine is relevant is treated as having economic substance under a conjunctive two-prong test only if—apart from Federal income tax effects—both:

(1) the transaction changes in a meaningful way the taxpayer's economic position; ( Code Sec. 7701(o)(1)(A) ) and

(2) the taxpayer has a substantial purpose for entering into the transaction. ( Code Sec. 7701(o)(1)(B) ) That is, the taxpayer's non-Federal-income-tax purpose for entering into a transaction must be “substantial.”

Background on penalties. For underpayments attributable to transactions entered into after Mar. 30, 2010, a 20% strict liability penalty applies to an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (as defined in Code Sec. 7701(o) ), or failing to meet the requirements of any similar rule of law. ( Code Sec. 6662(b)(6) ) The penalty rate is increased to 40% if the taxpayer doesn't adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return. ( Code Sec. 6662(i)(1) ) Code Sec. 6664 's reasonable cause exception doesn't apply to the Code Sec. 6662(b)(6) penalty. ( Code Sec. 6664(c)(2) ) Additionally, a maximum 20% strict liability penalty under Code Sec. 6676 also applies to refund claims based on any transaction described in Code Sec. 6662(b)(6) .

New guidance. The new LB&I directive provides instructions to examiners and their managers on determining when to seek the approval of the DFO in order to raise the economic substance doctrine. This approval was mandated by a prior LB&I directive.  designed to ensure consistent application of the associated strict liability penalty.

Once an examiner determines that raising the doctrine might be warranted, the directive sets out a series of four steps that the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

(1) The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely not appropriate. Among the factors indicating that the doctrine is inappropriate are that the transaction is not promoted by a tax department or outside advisors, is not highly structured, is at arm's length with unrelated third parties, and carries a significant risk of loss.

(2) The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely appropriate. These factors include that the transaction includes unnecessary steps, accelerates a loss or duplicates a deduction, has no credible business purpose apart from federal tax benefits, and is outside the taxpayer's ordinary business operations.

(3) The examiner must answer each of the following inquiries before seeking the approval of the appropriate DFO to apply the doctrine. If the answer to (i) through (iv) is affirmative, then application of the doctrine should not be pursued without specific approval of the examiner's manager in consultation with local counsel. In answering (v) and (vi), the examiner should seek the advice of his manager in consultation with local counsel.

(i) Is the transaction a statutory or regulatory election?

(ii) Is the transaction subject to a detailed statutory or regulatory scheme, and if so, does it comply with this scheme?

(iii) Does judicial or administrative precedent exist that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction, or upholds the transaction without reference to the doctrine?

(iv) Does the transaction involve tax credits (e.g., for low-income housing or alternative energy) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?

(v) Does another judicial doctrine more appropriately address the noncompliance that is being examined?

(vi) Does recharacterizing a transaction more appropriately address the noncompliance that is being examined?

(vii) In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? If not, it shouldn't be pursued without specific approval of the examiner's manager in consultation with local counsel.

(4) If an examiner completes the above inquiries and concludes that it is appropriate to seek approval to apply the doctrine, the examiner, in consultation with his manager and territory manager, should describe for the appropriate DFO in writing how the analysis was completed. The DFO should then review the written material provided and consult with counsel. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain their position. The DFO should convey the final decision to the examiner in writing.

Individual steps of multi-step transactions. The directive provided that when a transaction involves a series of interconnected steps with a common objective, the steps are generally viewed together in applying the above guidance. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps, such as when an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner must first seek guidance from their manager and consult with their local counsel.

Taxpayer notification. An examiner should notify a taxpayer that he is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the four-step analysis.

Penalties limited to economic substance doctrine. The directive also clarifies that, until further guidance is provided, the penalties under Code Sec. 6662(b)(6) and Code Sec. 6676 are limited solely to the application of the economic substance doctrine. They may not be imposed due to the application of any other similar “rule of law” or judicial doctrine, like the step transaction doctrine or substance over form.

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Guidance for Examiners and Managers on the Codified Economic

Substance Doctrine and Related Penalties

LB&I Control No: LB&I-4-

0711-015

Impacted IRM 20.1.1,

20.1.5

July 15, 2011

LB&I DIRECTIVE FOR INDUSTRY DIRECTORS

DIRECTOR, FIELD SPECIALISTS

DIRECTOR, PRE-FILING AND TECHNICAL GUIDANCE

DIRECTOR, INTERNATIONAL BUSINESS COMPLIANCE  

DIRECTOR, INTERNATIONAL INDIVIDUAL COMPLIANCE

 

FROM: Heather C. Maloy /s/ Heather C. Maloy

Commissioner, Large Business & International Division

SUBJECT: Guidance for Examiners and Managers on the Codified Economic

Substance Doctrine and Related Penalties  

BACKGROUND

Section 1409(a) of the Health Care and Education Reconciliation Act of 2010 (the “2010

Act”)  codified a conjunctive economic substance test in new section 7701(o).  The new

statute defines the economic substance doctrine as the common law doctrine under which

certain tax benefits are not allowable if the transaction does not have economic substance or

lacks a business purpose and states that “[t]he determination of whether the economic

substance doctrine is relevant to a transaction shall be made in the same manner as if [the

legislation] had never been enacted.”

The statute further states that “[i]n 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.”

As a result, enactment of section 7701(o) resolved the longstanding conflict among various

circuit courts of appeal regarding how the doctrine should be applied by codifying a two-part

conjunctive test.

In addition, the 2010 Act added section 6662(b)(6), which imposes a strict liability penalty of

20 percent (40 percent for undisclosed transactions) of any underpayment attributable to the

disallowance of claimed tax benefits by reason of the application of the economic substance

doctrine or failing to meet the requirements of any similar rule of law.  Amendments to section 6664 make clear that the “reasonable cause” exception is not applicable to this

penalty, and a corresponding amendment to section 6676 provides that a strict liability

penalty also applies to refund claims, although in that case the penalty is limited to 20

percent.

-----------------------------

Section 7701(o) and the related strict liability accuracy-related penalty apply to transactions

entered into after March 30, 2010, which was the date of enactment of the 2010 Act.

PURPOSE OF GUIDANCE

On September 14, 2010, an LB&I Directive, LMSB-20-0910-024, was issued relating to the

codification of the economic substance doctrine in the 2010 Act.  This directive stated that to

ensure consistent administration of the strict liability penalty related to the application of the

doctrine, any proposal to impose the doctrine, and thus the penalty, at the examination level

must be reviewed and approved by the appropriate Director of Field Operations (DFO).

The purpose of this LB&I Directive is to instruct examiners and their managers how to

determine when it is appropriate to seek the approval of the DFO in order to raise the

economic substance doctrine.  Once an examiner determines that raising the doctrine may

be appropriate, this directive sets forth a series of inquiries the examiner must develop and

analyze in order to seek approval for the ultimate application of the doctrine in the

examination.

In addition, this LB&I Directive provides that, until further guidance is issued, the penalties

provided in sections 6662(b)(6) and (i) and 6676 are limited to the application of the

economic substance doctrine and may not be imposed due to the application of any other

“similar rule of law” or judicial doctrine (e.g., step transaction doctrine, substance over form

or sham transaction).

This LB&I Directive has four steps.  First, an examiner should evaluate whether the

circumstances in the case are those under which application of the economic substance

doctrine to a transaction is likely not appropriate.  Second, an examiner should evaluate

whether the circumstances in the case are those under which application of the doctrine to

the transaction may be appropriate.  Third, if an examiner determines that the application of

the doctrine may be appropriate, the guidance provides a series of inquiries an examiner

must make before seeking approval to apply the doctrine.  Fourth, if an examiner and his or

her manager and territory manager determine that application of the economic substance

doctrine is merited, guidance is provided on how to request DFO approval.

Generally, in applying this LB&I Directive, when a transaction involves a series of

interconnected steps with a common objective, the term “transaction” refers to all of the

steps taken together.  However, in certain circumstances, it may be appropriate to apply this

guidance separately to one or more steps that are included within a series of arguably

interconnected steps.  This may be appropriate in situations where an integrated transaction

includes one or more tax-motivated steps that bear only a minor or incidental relationship to

a single common business or financial transaction.  If an examiner wants to apply this

guidance separately to one or more steps with a common objective, the examiner is required

to seek guidance from their manager and consult with their local counsel before doing so.

An examiner should notify a taxpayer that the examiner is considering whether to apply the

economic substance doctrine to a particular transaction as soon as possible, but not later

than when the examiner begins the analysis in the steps described below. STEP 1:  DOCTRINE LIKELY NOT APPROPRIATE

The following facts and circumstances tend to show that application of the economic

substance doctrine to a transaction is likely not appropriate.  If some of the factors described

in this section of the LB&I Directive apply to the transaction, and an examiner continues to

believe that the application of the doctrine is appropriate, the examiner should continue to

analyze the transaction using the guidance set forth in Steps 2-4. 

• Transaction is not promoted/developed/administered by tax department or outside

advisors

• Transaction is not highly structured

• Transaction contains no unnecessary steps

• Transaction that generates targeted tax incentives is, in form and substance,

consistent with Congressional intent in providing the incentives

• Transaction is at arm’s length with unrelated third parties

• Transaction creates a meaningful economic change on a present value basis (pretax)

• Taxpayer’s potential for gain or loss is not artificially limited

• Transaction does not accelerate a loss or duplicate a deduction

• Transaction does not generate a deduction that is not matched by an equivalent

economic loss or expense (including artificial creation or increase in basis of an

asset)

• Taxpayer does not hold offsetting positions that largely reduce or eliminate the

economic risk of the transaction

• Transaction does not involve a tax-indifferent counterparty that recognizes

substantial income

• Transaction does not result in the separation of income recognition from a related

deduction either between different taxpayers or between the same taxpayer in

different tax years

• Transaction has credible business purpose apart from federal tax benefits

• Transaction has meaningful potential for profit apart from tax benefits

• Transaction has significant risk of loss

• Tax benefit is not artificially generated by the transaction

• Transaction is not pre-packaged

• Transaction is not outside the taxpayer’s ordinary business operations.

In addition, it is likely not appropriate to raise the economic substance doctrine if the

transaction being considered is related to the following circumstances.

• The choice between capitalizing a business enterprise with debt or equity 

• A U.S. person’s choice between utilizing a foreign corporation or a domestic

corporation to make a foreign investment 

• The choice to enter into a transaction or series of transactions that constitute a

corporate organization or reorganization under subchapter C 

• The choice to utilize a related-party entity in a transaction, provided that the arm's

length standard of section 482 and other applicable concepts are satisfied. 

STEP 2:  DOCTRINE MAY BE APPROPRIATE

The following facts and circumstances tend to show that application of the economic

substance doctrine may be appropriate. • Transaction is promoted/developed/administered by tax department or outside

advisors 

• Transaction is highly structured 

• Transaction includes unnecessary steps 

• Transaction is not at arm’s length with unrelated third parties 

• Transaction creates no meaningful economic change on a present value basis (pretax)  

• Taxpayer’s potential for gain or loss is artificially limited 

• Transaction accelerates a loss or duplicates a deduction 

• Transaction generates a deduction that is not matched by an equivalent economic

loss or expense (including artificial creation or increase in basis of an asset) 

• Taxpayer holds offsetting positions that largely reduce or eliminate the economic risk

of the transaction 

• Transaction involves a tax-indifferent counterparty that recognizes substantial

income 

• Transaction results in separation of income recognition from a related deduction

either between different taxpayers or between the same taxpayer in different tax

years 

• Transaction has no credible business purpose apart from federal tax benefits 

• Transaction has no meaningful potential for profit apart from tax benefits 

• Transaction has no significant risk of loss 

• Tax benefit is artificially generated by the transaction 

• Transaction is pre-packaged 

• Transaction is outside the taxpayer’s ordinary business operations. 

STEP 3:  DEVELOPMENT OF CASE FOR APPROVAL

If after applying the guidance set forth above an examiner believes that the application of the

economic substance doctrine may be appropriate, the examiner must answer the following

series of inquiries before seeking the approval of his or her appropriate DFO to apply the

doctrine.

1. Is the transaction a statutory or regulatory election?  If so, then the application of the

doctrine should not be pursued without specific approval of the examiner’s manager

in consultation with local counsel. 

2. Is the transaction subject to a detailed statutory or regulatory scheme?  If so, and the

transaction complies with this scheme, then the application of the doctrine should not

be pursued without specific approval of the examiner’s manager in consultation with

local counsel. 

3. Does precedent exist (judicial or administrative) that either rejects the application of

the economic substance doctrine to the type of transaction or a substantially similar

transaction or upholds the transaction and makes no reference to the doctrine when

considering the transaction?  If so, then the application of the doctrine should not be

pursued without specific approval of the examiner’s manager in consultation with

local counsel. 

4. Does the transaction involve tax credits (e.g., low income housing credit, alternative

energy credits) that are designed by Congress to encourage certain transactions that

would not be undertaken but for the credits?  If so, then the application of the

doctrine should not be pursued without specific approval of the examiner’s manager

in consultation with local counsel. 

5. Does another judicial doctrine (e.g., substance over form or step transaction) more

appropriately address the noncompliance that is being examined?  If so, those

doctrines should be applied and not the economic substance doctrine.  To determine whether another judicial doctrine is more appropriate to challenge a transaction, an

examiner should seek the advice of the examiner’s manager in consultation with

local counsel. 

6. Does recharacterizing a transaction (e.g., recharacterizing debt as equity,

recharacterizing someone as an agent of another, recharacterizing a partnership

interest as another kind of interest, or recharacterizing a collection of financial

products as another kind of interest) more appropriately address the noncompliance

that is being examined?  If so, recharacterization should be applied and not the

economic substance doctrine.  To determine whether recharacterization is more

appropriate to challenge a transaction, an examiner should seek the advice of the

examiner’s manager in consultation with local counsel. 

7. In considering all the arguments available to challenge a claimed tax result, is the

application of the doctrine among the strongest arguments available?  If not, then the

application of the doctrine should not be pursued without specific approval of the

examiner’s manager in consultation with local counsel. 

STEP 4:  DFO APPROVAL

If an examiner completes the inquiries described above and as a result concludes that it is

appropriate to seek approval for the application of the economic substance doctrine, the

examiner, in consultation with his or her manager and territory manager, should describe for

the appropriate DFO in writing how the analysis described in the guidance above was

completed.  The DFO in considering an examiner’s request for approval should review the

written material provided and consult with Counsel before a decision is made.  If the DFO

believes it is appropriate to approve the request, the DFO should provide the taxpayer an

opportunity to explain their position, either in writing or in person (at the DFO’s discretion),

addressing whether the doctrine should be applied to a particular transaction.  Once the DFO

has made a final decision, that decision should be conveyed to the examiner in writing.

This LB&I Directive is not an official pronouncement of law, and cannot be used, cited, or

relied upon as such.

cc: Deputy Commissioner (Operations)

      Deputy Commissioner (International)

      Division Counsel (LB&I)

--------------------------------

7701

(o) New Law AnalysisWG&L Treatises 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) New Law Analysis the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

 (B) New Law Analysis the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

 (2) WG&L Treatises Special rule where taxpayer relies on profit potential.

(A) New Law AnalysisWG&L Treatises 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) New Law Analysis 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) New Law Analysis 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) New Law Analysis 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) New Law AnalysisWG&L Treatises 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) New Law AnalysisWG&L Treatises 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) New Law Analysis 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) New Law Analysis Transaction. The term “transaction” includes a series of transactions.

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