The Codified Economic Substance Doctrine and Related Penalties

By David Yu, SingerLewak LLP, Irvine, CA

Editor: Mark G. Cook, CPA, MBA

Procedure & Administration

The IRS issued a directive on July 15, 2011, from its Large Business and International (LB&I) Division (LB&I-4-0711-015) to help examiners and their managers determine the appropriateness of seeking the approval of the director of field operations (DFO) when raising the economic substance doctrine. This was a follow-up to a previous LB&I directive (LMSB-20-0910-024) issued on September 14, 2010, that summarized the codification of the economic substance doctrine and related penalties. The July 15 directive further details a multistep process that the examiner must develop before the ultimate application of the doctrine in the examination. It also provides guidance on related penalties that might be imposed upon the application of the doctrine.

Background on the Economic Substance Doctrine

The Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (the Health Care Act), codified a conjunctive economic substance test in new Code Sec. 7701(o). Sec. 7701(o) disallows certain tax benefits if the transaction does not have economic substance or a business purpose. The new statute is effective for transactions entered into after March 30, 2010, which was the date of the act’s enactment. Under this new Code section, a transaction is considered to have economic substance as long as it meets a two-part conjunctive test. A transaction will have economic substance if, apart from federal income tax effects:

  • The transaction changes in a meaningful way the taxpayer’s economic position; and
  • The taxpayer has a substantial purpose for entering into such transaction.

Background on Related Penalties

The Health Care Act also added Sec. 6662(b)(6), which imposes a 20% strict liability penalty for any underpayment attributable to claimed tax benefits that are disallowed because of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty rate is increased to 40% when the underpayment is attributable to one or more “nondisclosed noneconomic substance transactions,” which are any transactions for which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return (Sec. 6662(i)).

Amendments to Sec. 6664 clarify that the reasonable cause exception does not apply to the Sec. 6662(b)(6) penalty (Sec. 6664(d)(2)). In addition, a corresponding amendment to Sec. 6676 specifies that a strict liability penalty limited to 20% also applies to refund or credit claims based on any transaction described in Sec. 6662(b)(6).

This LB&I directive clarifies that until further guidance is issued, the penalties under Secs. 6662(b)(6) and (i) and 6676 are limited solely to the application of the economic substance doctrine and may not be subject to the application of any other similar rule of law or judicial doctrine, such as the step-transaction, substance-over-form, or sham-transaction doctrines.

Four Steps to Develop and Analyze

Once an examiner determines that raising the economic substance doctrine is appropriate, the LB&I directive lays out four steps that the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

Step 1—Doctrine likely not appropriate: The examiner must determine whether the facts and circumstances of a transaction are similar to those listed below, which tend to show that application of the economic substance doctrine is likely not appropriate:

  • Transaction is not promoted/developed/administered by tax department or outside advisers;
  • 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 transaction’s economic risk;
  • 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 for the same taxpayer between different tax years;
  • Transaction has a credible business purpose apart from federal tax benefits;
  • Transaction has meaningful potential for profit apart from its tax benefits;
  • Transaction has significant risk of loss;
  • Tax benefit is not artificially generated by the transaction;
  • Transaction is not prepackaged; or
  • Transaction is within the taxpayer’s ordinary business operations.

In addition, it is likely not appropriate to raise the economic substance doctrine if the transaction is related to the following circumstances:

  • The choice between capitalizing a business enterprise with debt or equity;
  • A U.S. person’s choice between using 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; or
  • The choice to use a related-party entity in a transaction provided that the arm’s-length standard of Sec. 482 and other applicable concepts are satisfied.

If the examiner finds that some of the factors in step 1 do apply to the transaction, he or she is directed to then further analyze the transaction in the succeeding steps.

Step 2—Doctrine may be appropriate: The examiner must determine whether the facts and circumstances of a transaction are similar to those listed below, which tend to show that application of the economic substance doctrine may be appropriate:

  • Transaction is promoted/developed/administered by a tax department or outside advisers;
  • 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 of 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 for the same taxpayer between 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 prepackaged; or
  • Transaction is outside the taxpayer’s ordinary business operations.

Step 3—Development of case for approval: If after step 2 the examiner believes that the application of the economic substance doctrine may be appropriate, he or she must then answer each of the following inquiries before seeking the approval of the appropriate DFO to apply the doctrine. If the answer to questions 1–4 or 7 is affirmative, the examiner should not pursue application of the doctrine without the specific approval of the examiner’s manager in consultation with local IRS counsel. For questions 5 and 6, the examiner should seek the advice of his or her manager in consultation with local counsel.

  1. Is the transaction a statutory or regulatory election?
  2. Is the transaction subject to a detailed statutory or regulatory scheme, and does it comply with this scheme?
  3. Does judicial or administrative pre-cedent 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 and makes no reference to the doctrine when considering the transaction?
  4. Does the transaction involve tax credits (e.g., the low-income housing credit or alternative energy credits) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?
  5. Does another judicial doctrine (e.g., substance over form or step transaction) more appropriately address the noncompliance that is being examined?
  6. Does recharacterizing a transaction (e.g., recharacterizing (a) debt as equity, (b) someone as an agent of another, (c) a partnership interest as another kind of interest, or (d) a collection of financial products as another kind of interest) more appropriately address the noncompliance that is being examined?
  7. In considering all the arguments available to challenge a claimed tax result, is the application of the economic substance doctrine among the strongest arguments available?

Step 4—DFO approval: If an examiner completes the inquiries in step 3 and concludes that it is appropriate to seek approval to apply the economic substance doctrine, the examiner, in consultation with his or her manager and territory manager, should describe in writing for the appropriate DFO how the analysis was completed. The DFO should then review the written material and consult with counsel before a decision is made. If the DFO believes it is appropriate to approve the request, he or she should give the taxpayer an opportunity to explain its position, either in writing or in person, addressing whether the doctrine should be applied to a particular transaction. The DFO should convey the final decision to the examiner in writing.


EditorNotes

Mark Cook is a partner at SingerLewak LLP in Irvine, CA.

The editor would like to offer a special thanks to Christian J. Burgos, J.D., LL.M., for his assistance with this column.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com .

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

Newsletter Articles

AWARD

James M. Greenwell Wins 2014 Best Article Award

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

 

FEATURE

How Legal Marijuana Businesses Are Treated Federally

This article examines the tax problems that these businesses face and warns that professionals may provide services to them at their peril.