Economic substance doctrine is codified and
clarified in Code Sec. 7701(o). Code Sec. 7701(o) codifies and clarifies the
economic substance doctrine by providing that a transaction (or series of
transactions) to which the doctrine is relevant has economic substance only if:
(1) the transaction changes the taxpayer's position in a meaningful way (apart
from federal income tax effects), and (2) the taxpayer has a substantial
purpose (apart from federal income tax effects) for entering into the transaction.
(Item (1) is referred to below as the “objective test” and item (2) is referred
to as the “subjective test” and this list is referred to as the economic
substance test list.) Code Sec. 7701(o)(1). In applying this list, a
“transaction” includes a series of transactions. Code Sec. 7701(o)(5)(D). This
clarifies that the economic substance doctrine involves a conjunctive analysis,
i.e., there must be an inquiry as to the objective effects of the transaction
on the taxpayer's economic position and an inquiry as to the taxpayer's
subjective motives for engaging in the transaction. A transaction must satisfy
both tests, i.e., the transaction must change in a meaningful way (apart from
Federal income tax effects) the taxpayer's economic position and the taxpayer
must have a substantial non-Federal-income-tax purpose for entering into the
transaction, for a transaction to be treated as having economic substance. This
clarification eliminates the disparity that has existed among the Federal
circuit courts as to the application of the doctrine, and modifies its
application in those circuits in which either a change in economic position or
a non-tax business purpose (without having both) was sufficient to satisfy the
economic substance doctrine. Thus, the definition includes any doctrine that
denies tax benefits for lack of economic substance, for lack of business
purpose, or for lack of both. Joint Comm Staff, Tec Expln of the Revenue
Provisions of the Reconciliation Act of 2010, as Amended in Combination With
the Patient Protection and affordable Care Act (JCX-18–10), 3/21/2010,
pp.153–154,
OBSERVATION: Eliminating the conflict among the
circuits courts by making clear that both the subjective test and the objective
tests on the economic substance test list must be satisfied is one clear result
of this provision. It has been argued that this is the only significant change
(apart from the addition of special Code Sec. 6662(i) penalty provisions), see
following observation.
OBSERVATION: Code Sec. 7701(o) is headed
“Clarification of the economic substance doctrine” rather than codification,
and it has been suggested that this clarification in the economic substance
test list is the sole significant change, especially since determination of whether
the doctrine is relevant is made as if the provision had never been enacted,
see ¶77,014.3502. However, the Joint Committee discussion adds that the
provision “enhances” the application of the doctrine, thus suggesting that the
provision accomplishes something in addition to clarification. Joint Comm
Staff, Tec Expln of the Revenue Provisions of the Reconciliation Act of 2010,
as Amended in Combination With the Patient Protection and affordable Care Act
(JCX-18–10), 3/21/2010, pg. 152, see ¶77,011.0009. Moreover, the profit test
discussed at ¶77,014.3506 and ¶77,014.3507 may effect a significant change. To
have economic substance, the transaction must be rationally related to a useful
non-tax purpose that is plausible in light of the taxpayer's conduct and useful
in light of the taxpayer's economic situation and intentions. Both the utility
of the stated purpose and the rationality of the means chosen to effectuate it
must be evaluated in accordance with commercial practices in the relevant
industry. A rational relationship between purpose and means ordinarily will not
be found unless there was a reasonable expectation that the nontax benefits
will be at least commensurate with the transaction costs. Joint Comm Staff, Tec
Expln of the Revenue Provisions of the Reconciliation Act of 2010, as Amended
in Combination With the Patient Protection and affordable Care Act (JCX-18–10),
3/21/2010, pg. 154, see ¶77,011.0009.
The “economic substance doctrine” is defined as
the common law doctrine under which the Federal tax benefits of a transaction
are not allowable if the transaction does not have economic substance or lacks
a business purpose. Code Sec. 7701(o)(5)(A). Thus, the definition includes any
doctrine that denies tax benefits for lack of economic substance, for lack of
business purpose, or for lack of both. Joint Comm Staff, Tec Expln of the
Revenue Provisions of the Reconciliation Act of 2010, as Amended in Combination
With the Patient Protection and affordable Care Act (JCX-18–10), 3/21/2010, pg.
154, see ¶77,011.0009.
OBSERVATION: A transaction may be subject to
the step transaction and substance over form doctrines (which establish the
relevant facts) in addition to being tested for economic substance. The IRS
will continue to rely on relevant case law under the common-law economic
substance doctrine in applying the two-prong conjunctive test at (1) and (2)
above. Thus, in determining if a transaction sufficiently affects the
taxpayer's economic position to satisfy the requirements at (1), the IRS will
apply cases under the common-law economic substance doctrine (as identified in
Code Sec. 7701(o)(5)(A)) as to whether the tax benefits of a transaction are
not allowable because the transaction does not satisfy the economic substance
prong of the economic substance doctrine. Similarly, in determining whether a
transaction has a sufficient nontax purpose to satisfy the requirements at (2),
IRS will apply cases under the common-law economic substance doctrine
pertaining to whether the tax benefits of a transaction are not allowable
because the transaction lacks a business purpose. Notice 2010-62, 2010-40 IRB
411. The IRS will challenge taxpayers who seek to rely on prior case law under
the common-law economic substance doctrine for the proposition that a transaction
will be treated as having economic substance merely because it satisfies either
(1) above (or its common-law corollary) or (2) above (or its common-law
corollary). For all transactions subject to Code Sec. 7701(o) the IRS will
apply a two-prong conjunctive test consistent with Code Sec. 7701(o).
Notice 2010-62, 2010-40 IRB 411. Consistent
with the Code Sec. 7701(o)(1) relevancy requirement and Code Sec. 7701(o)(5)(C)
(see ¶77,014.3502), the IRS will continue to analyze when the economic
substance doctrine will apply in the same fashion as it did before the
enactment of Code Sec. 7701(o). If authorities, before the enactment of Code
Sec. 7701(o), provided that the economic substance doctrine wasn't relevant to
whether certain tax benefits are allowable, the IRS will continue to take the
position that the economic substance doctrine isn't relevant to whether those
tax benefits are allowable. The IRS anticipates that the case law regarding the
circumstances in which the economic substance doctrine is relevant will
continue to develop, see ¶77,014.3502. Notice 2010-62, 2010-40 IRB 411. To
ensure consistent administration of the Code Sec. 6662(b)(6) strict liability
penalty related to the application of the economic substance doctrine (see
¶66,624.12), 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). An IRS Directive instructs 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, see ¶77,014.3502. , Directive
providing guidance for examiners and managers on the codified economic
substance doctrine and related penalties, 7/15/2011. For not taking into account
state tax benefits and accounting benefits that are related to a federal income
tax effect, see ¶77,014.3501. For determining if the economic substance
doctrine is relevant, see ¶77,014.3502. For transactions to which the economic
substance doctrine normally won't apply, see ¶77,014.3503. For applying the
economic substance doctrine to disallow one element of a larger transaction,
see ¶77,014.3504. For applying the economic substance test to leasing
transactions, see ¶77,014.3505. For the special rule where the taxpayer relies
on the profit potential of a transaction to establish economic substance, see
¶77,014.3506. For the application of the economic substance doctrine to
individuals, see ¶77,014.3508. Prior law. For transactions entered into before
Mar. 31, 2010, Code Sec. 7701(o) did not apply. Sec. 1409(e)(1), PL 115-152,
3/30/2010. Notice 2010-62, 2010-40 IRB 411, also didn't apply. Notice 2010-62,
2010-40 IRB411
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