In July, IRS's Large Business & International (LB&I) Division issued guidance (LB&I-4-0711-015, 7/15/11; the “LB&I Directive”) to examiners and managers concerning the application of the economic substance doctrine. This guidance will significantly narrow the situations in which the economic substance doctrine can be applied and, more importantly, will limit the ability of agents to assert the 40% penalty that is automatically imposed (absent disclosure) if a transaction lacks economic substance.

Background. The economic substance doctrine is one of the long-standing judicial doctrines that must be taken into account in the implementation of the provisions of the Code. In general, tax benefits from a transaction will not be allowed to a taxpayer if the transaction that gives rise to those benefits lacks economic substance (i.e., does not change the taxpayer's economic position) independent of its federal income tax considerations. This test looks to whether there is a realistic possibility that a profit can be obtained from the transaction, because taxpayers do not usually enter into transactions in order to incur a loss.

The test for economic substance is closely related to the business purpose test, under which tax benefits will be allowed only if they arise in a transaction that the taxpayer entered into for business purposes and not just to obtain tax benefits. When these tests are looked at together, the effect is that a transaction will be found to have economic substance, and therefore will not be disregarded, only if the transaction changes the taxpayer's economic position and is entered into for a business purpose other than to obtain tax benefits.

Although courts generally agreed as to the purpose of the economic substance doctrine, there was a split in the circuits concerning its application. A majority of the courts applied the “conjunctive test” under which a transaction lacked economic substance unless the transaction was found to have both economic substance (under an objective test requiring the court to find that there was a realistic possibility of a profit in the transaction) and business purpose (under a subjective test requiring the court to determine whether the taxpayer was motivated to enter into the transaction for a business purpose other than tax avoidance). Several courts, however, concluded that the tax effects of a transaction had to be respected if the transaction had either economic substance or a business purpose. This was the “disjunctive test.”

“Codification” of economic substance. The economic substance doctrine was added to the Code by section 1409 of the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152, 3/30/10). While the Act section is labeled “Codification of Economic Substance Doctrine and Penalties,” new Code Sec. 7701(o) is titled “Clarification of Economic Substance Doctrine.”

Code Sec. 7701(o)(1) primarily clarifies that the economic substance doctrine is a conjunctive test, rejecting the disjunctive approach. Specifically, “[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.”

The Joint Committee explanation emphasized that no inference was intended as to the proper application of the economic substance doctrine; the doctrine should continue to be applied in the same manner as if Code Sec. 7701(o) had never been enacted. Thus, the “codification” of the economic substance doctrine was not intended to change the present-law standards other than to clarify that the test was conjunctive rather than disjunctive.

Penalty. The most important aspect of the new legislation may not be the provisions concerning the definition of economic substance, but rather the penalty that is imposed on transactions that lack such substance. Along with the enactment of Code Sec. 7701(o) , Code Sec. 6662 was amended to impose a penalty equal to 20% of the portion of any underpayment of tax attributable, under Code Sec. 6662(b)(6), to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. In determining whether this penalty applies, Code Sec. 6662(i)(2)provides that amendments or supplements to an already-filed return are not taken into account if the amendment or supplement is filed after the date the taxpayer is first contacted by IRS regarding the examination of the return (or such earlier date as specified by Regulations).

Significantly, Code Sec. 6664(c)(2) provides that the “reasonable cause” exception that generally applies to other penalties is not applicable with respect to an understatement attributable to the lack of economic substance in a transaction. Accordingly, the penalty is a “strict liability” or “no fault” penalty—no matter the facts and circumstances surrounding the transaction, if a court determines that the transaction lacked economic substance, the 20% penalty applies.

As if this 20% strict liability penalty were not severe enough, Code Sec. 6662(i)(1) provides that the 20% penalty is increased to 40% with respect to any portion of any underpayment attributable to a transaction that is found to lack economic substance and with respect to which the relevant facts affecting the tax treatment of the transaction were not adequately disclosed in the return or in a statement attached to the return.

Examination guidance. On Sept. 14, 2010, IRS instructed all agents and managers that any application of the economic substance doctrine, and the related penalty, would need to be approved by the appropriate Director of Field Operations (DFO) within IRS. This instruction was intended to assure both consistency in application of the doctrine and prevent its assertion in inappropriate situations.

In order to advise examiners and their managers how to determine when it is appropriate to seek the approval of the appropriate DFO in order to raise the economic substance doctrine, IRS issued the LB&I Directive. If an examiner believes that the doctrine may be applicable to a transaction, the LB&I Directive sets forth a series of inquiries that the examiner must develop and analyze in order to seek approval for the ultimate application of the economic substance doctrine.

The LB&I Directive provides for a four-step process. First, an examiner must evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate. The LB&I lists Step 1 facts and circumstances that tend to show that e 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 remaining guidance set forth in the LB&I Directive.

Second, an examiner must evaluate whether the circumstances in the case are those under which the application of the doctrine to a transaction may be appropriate.

Third, if after applying the guidance set forth in Steps 1 and 2, an examiner believes that the application of the economic substance doctrine may be appropriate, the examiner must answer a series of inquiries before seeking the approval of the appropriate DFO to apply the doctrine.

If an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, they should describe for the appropriate DFO in writing how the analysis described in the guidance above was completed. In considering an examiner's request for approval, the DFO should 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 its 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.

Finally, the LB&I Directive addresses the application of penalties under Code Sec. 6662(b)(6). As noted above, this is a 40% no-fault penalty (20% if there is adequate disclosure) which is applicable to transactions in which the claimed tax benefits are not available by reason of application of the economic substance doctrine or failing to meet the requirement of any similar rule of law. This penalty guidance is particularly helpful because it clarifies that as long as a deficiency arises as a result of something other than the economic substance doctrine, the penalties will not be applied.

Conclusion. The “step” analysis provided by IRS provides a practical way for examiners to determine whether the economic substance doctrine could be relevant to a transaction. Furthermore, if a taxpayer can point out that none of the factors in Step 1 are satisfied, then the examiner is not supposed to consider the economic substance doctrine, i.e., the application of Steps 2 to 4 should not be considered unless Step 1 is met. This is a practical approach that will allow taxpayers to attempt to persuade an examiner that the economic substance doctrine is not applicable.

www.irstaxattorney.com 888-712-7690