Codified Economic Substance Update: IRS Issues More Guidance

By Shamik Trivedi, J.D., LL.M., Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

Procedure & Administration

The IRS on Oct. 9 issued a notice providing additional guidance on the codified economic substance doctrine under Sec. 7701(o) and related penalty amendments.

Notice 2014-58 amplifies Notice 2010-62 and provides guidance on the definition of "transaction" in applying the economic substance doctrine under Sec. 7701(o) and on the meaning of "similar rule of law" under the Sec. 6662(b)(6) accuracy-related penalty. It is effective for transactions entered into after March 30, 2010.

Congress codified the economic substance doctrine as part of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, by adding Sec. 7701(o), which states that a transaction has economic substance if it meets a two-part test: (1) The transaction must change in a meaningful way, apart from federal income tax effects, a taxpayer's economic position; and (2) the taxpayer must have a substantial purpose, apart from federal income tax effects, for entering into the transaction. The term "economic substance" is defined under Sec. 7701(o)(5)(A) as the common law doctrine that disallows tax benefits under subtitle A of the Code, if the transaction that produces those benefits lacks economic substance or a business purpose.

Definition of "Transaction"

Notice 2014-58 applies an aggregation definition to "transaction," in that a transaction "generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan." Thus, when a plan that generates a tax benefit involves a series of interconnected steps with a common objective, the transaction is considered to include all of the steps in the aggregate—resulting in each step's being considered when analyzing whether the transaction as a whole lacks economic substance.

However, when a plan includes a series of steps, including a tax-motivated step that is not necessary to achieve a nontax objective, the notice indicates that the IRS may apply a disaggregation approach to determine whether any of the individual tax-motivated steps is considered a transaction subject to the economic substance doctrine. So the IRS is free to aggregate or disaggregate steps of an overall transaction in assessing the application of the economic substance doctrine on a case-by-case basis.

This definition is consistent with the legislative history of the term "transaction" under Sec. 7701(o)(5)(D) in the House report on the Health Care and Education Reconciliation Act, which the notice refers to. That report explains that the provision "does not alter the court's ability to aggregate, disaggregate, or otherwise recharacterize a transaction" when applying the economic substance doctrine (H.R. Rep't No. 111-443, 111th Cong., 2d Sess. 296).

Definition of "Similar Rule of Law"

Secs. 6662(b)(6) and 6662(i) together impose a per se 40% penalty for transactions that fail the economic substance doctrine or a "similar rule of law." Notice 2014-58 provides that a similar rule of law is a rule or doctrine that applies the same factors or analysis as required under Sec. 7701(o), even if the doctrine is called something different. The notice gives the example of the "sham transaction doctrine." Specifically, the notice defines "similar rule of law" to mean a rule or doctrine that disallows the tax benefits under subtitle A of the Code related to the transaction because (1) the transaction does not change a taxpayer's economic position in a meaningful way (apart from federal income tax effects); or (2) the taxpayer did not have a substantial purpose (apart from federal income tax effects) for entering into the transaction. The notice also clarified that the IRS will not apply a penalty under Sec. 6662(b)(6) unless the IRS also raises Sec. 7701(o) to support the underlying adjustments.

Even with this additional guidance, it remains to be seen exactly how or when the IRS will assert the codified economic substance doctrine. LB&I-4-0711-015 provides for a specific set of factors for examiners and their managers in the Large Business & International division to consider and procedures to follow in seeking approval through the IRS chain of command to assert the penalty. Presumably, a decision by the government to assert the penalty will not be taken lightly.


Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

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

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