Economic Substance Doctrine Clarified

From the IRS

The IRS provided guidance defining “transaction” for purposes of applying the Sec. 7701(o) economic substance doctrine and “similar rule of law” for purposes of the Sec. 6662(b)(6) accuracy-related penalty (Notice 2014-58).

The economic substance doctrine is a common law judicial doctrine that disallows tax benefits of a transaction if the transaction lacks economic substance or a business purpose. The doctrine was codified in 2010 in Sec. 7701(o), which defines a transaction as having economic substance if (1) the transaction changes in a meaningful way (apart from its federal income tax effects) the taxpayer’s economic position; and (2) the taxpayer has a substantial purpose (apart from those tax effects) for entering into the transaction.

In the notice, the IRS states that for purposes of determining whether the codified economic substance doctrine applies, 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. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.

When a plan that generated a tax benefit has interconnected steps with a common objective, the IRS will define “transaction” as including all of the steps together in aggregate. Every step will be considered when analyzing whether the transaction as a whole lacks economic substance. If a series of steps includes a tax-motivated step that is unnecessary to achieve a nontax objective, the IRS will disaggregate the transactions.

Sec. 6662(b)(6) imposes a penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance under Sec. 7701(o) or fails to meet the requirements of any similar rule of law. According to the IRS, “similar rule of law” means a rule or doctrine that applies the same factors and analysis as under Sec. 7701(o) for an economic substance analysis, even if a different term (e.g., “sham transaction doctrine”) is used to describe the rule or doctrine.

However, the IRS considers Code sections and Treasury regulations, other than Sec. 7701(o) and the regulations under that section, that disallow tax benefits to not be similar rules of law for purposes of Sec. 6662(b)(6). Therefore, the IRS will not apply a penalty under Sec. 6662(b)(6) (or otherwise argue that a transaction is described in Sec. 6662(b)(6)) unless it also raises Sec. 7701(o) to support the underlying adjustments.

These rules apply to transactions entered into after March 30, 2010, the date Sec. 7701(o) was enacted.