economic substance doctrine section 7701(o)

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,

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. .

 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), 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.

 To ensure consistent administration of the Code Sec. 6662(b)(6) strict liability penalty related to the application of the economic substance doctrine.

Alvin Brown & Associataes, PLLC

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