Editor: Uzell T. Williams-Freeman, CPA
On April 22, 2022, the IRS issued a memorandum to all Large Business & International Division (LB&I) and Small Business/Self-Employed Division (SB/SE) examination employees to communicate updated guidance for examiners and managers on the economic substance doctrine and related penalties (LB&I-04-0422-0014). The memorandum makes it easier for the IRS to assert that a transaction lacks economic substance or a business purpose by removing the previously required four-step process for relying on the economic substance doctrine, including the requirement for executive approval.
The memorandum’s guidance supersedes the instructions in Internal Revenue Manual (IRM) Section 4. 46.4.12.9, Economic Substance Doctrine; IRM Exhibit 4.46.4-4, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties; and IRM Section 20. 1.5.13.2, Penalty Administration, and will be added to IRM Section 4.10.13, Examination of Returns, Certain Technical Issues.
After first reviewing the background of the economic substance doctrine, the authors describe the previous IRS approach to the doctrine and then explain the changes set forth in the memorandum, providing some practical tips.
Background on the economic substance doctrine
Though historically a judicial concept, the economic substance doctrine was codified by Congress in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, by adding Sec. 7701(o), which defines the doctrine as follows:
The term “economic substance doctrine” means the common law doctrine under which tax benefits … with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. [Sec. 7701(o)(5)(A)]
Sec. 7701(o)(1)(B) requires that the taxpayer have a substantial purpose, apart from any federal income tax benefit, for entering into the transaction.
Sec. 6662(b)(6) was also added to implement Sec. 7701(o) by imposing a 20% penalty on any underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance. Sec. 6676 extends the penalty to refund claims, and Sec. 6662(i) increases the penalty to 40% for nondisclosed transactions. This penalty is strict-liability, with no reasonable-cause defense and no penalty relief even if a taxpayer receives an opinion on the transaction. Accordingly, if a transaction is determined to lack economic substance, the tax benefits of the transaction are disallowed and the strict-liability penalty applies.
The Joint Committee on Taxation ( JCT) report for Sec. 7701(o) ( JCX-18-10) provides certain safe harbors addressing when the doctrine is not meant to apply. These include “certain basic business transactions,” including:
- 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; and
- 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.
The JCT report also provides that “it is not intended” that certain tax credits, such as those under Secs. 42, 45, 45D, 47, and 48, be disallowed in a transaction involving “the type of activity that the credit was intended to encourage.”
Previous IRS approach
To understand how the memorandum makes it easier for the IRS to assert that a transaction lacks economic substance, it is necessary to summarize the detailed four-step process that was previously required for relying on the doctrine. Prior to the memorandum, the IRS had addressed the economic substance doctrine in a variety of notices and directives.
Robust guidance for examiners and their managers regarding the codified economic substance doctrine and related penalties was set forth in IRM Section 4.46.4 and IRM Exhibit 4. 46.4-4.
IRM Section 4.46.4.12.9 summarized the four steps examiners were required to take before a penalty could be asserted under Secs. 6662(b)(6) and 6662(i), stating:
Step one — DOCTRINE LIKELY NOT APPROPRIATE: The examiners must evaluate a number of factors that tend to show that application of the economic substance doctrine to a transaction is likely not appropriate. If the examiner continues to believe that the doctrine applies, go to step two.
Step two — DOCTRINE MAY BE APPROPRIATE: Requires the examiner to evaluate further whether additional circumstances in the case are those that tend to show that application of the doctrine is appropriate.
Step three — DEVELOPMENT OF CASE FOR APPROVAL: If the examiner continues to believe the application of the doctrine is warranted after conducting steps 1 and 2, a series of seven inquiries must be made before seeking approval to apply the doctrine.
Step four — DFO [director of field operations] APPROVAL: If the examiner and his or her manager and territory manager determine that the application of the doctrine is merited, guidance is provided on how to request DFO approval.
The four steps were elaborated upon in IRM Exhibit 4.46.4-4. The guidance there for Step 1 provided 18 facts and circumstances that tend to show the application of the economic substance doctrine to a transaction is likely not appropriate, such as that the transaction generates targeted tax incentives consistent with congressional intent in providing the incentives. Additionally, the guidance provided that it is “likely not appropriate to raise the economic substance doctrine” for transactions related to the four “basic business transaction” safe harbors listed above in the JCT report.
The inquiries required in Step 3 of IRM Section 4.46.4.12.9 were particularly important and demonstrated a preference for other approaches/ doctrines when possible and appropriate. IRM Exhibit 4.46.4-4 listed the seven inquiries to be made under this step:
- Is the transaction a statutory or regulatory election? If so, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel.
- Is the transaction subject to a detailed statutory or regulatory scheme? If so, and the transaction complies with this scheme, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel.
- Does precedent exist (judicial or administrative) 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? If so, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel.
- Does the transaction involve tax credits (e.g., low-income housing credit, alternative energy credits) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits? If so, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel.
- Does another judicial doctrine (e.g., substance over form or step transaction) more appropriately address the noncompliance that is being examined? If so, those doctrines should be applied and not the economic substance doctrine. To determine whether another judicial doctrine is more appropriate to challenge a transaction, an examiner should seek the advice of the examiner’s manager in consultation with local counsel.
- Does recharacterizing a transaction (e.g., recharacterizing debt as equity, recharacterizing someone as an agent of another, recharacterizing a partnership interest as another kind of interest, or recharacterizing a collection of financial products as another kind of interest) more appropriately address the noncompliance that is being examined? If so, recharacterization should be applied and not the economic substance doctrine. To determine whether recharacterization is more appropriate to challenge a transaction, an examiner should seek the advice of the examiner’s manager in consultation with local counsel.
- In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? If not, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel.
IRM Exhibit 4.46.4-4 provided that, to comply with Step 4 (DFO approval), the examiner, in consultation with his or her manager and territory manager, “should describe for the appropriate DFO in writing how the analysis … was completed.” The DFO was required to review the written material provided and consult with Counsel before a decision was made. If the DFO believed the request to impose the economic substance penalty was appropriate, the DFO was instructed to provide the taxpayer an opportunity to explain their position, addressing whether the doctrine should be applied to the transaction at issue.
Finally, IRM Exhibit 4.46.4-4 required that the taxpayer be notified as soon as possible that an examiner was considering whether to apply the economic substance doctrine to a particular transaction, but not later than when the examiner began the four-step analysis.
April 2022 memorandum
In the April 2022 memorandum, the IRS has quietly but markedly departed from its previously established procedure for raising the economic substance doctrine argument and asserting related penalties under Secs. 6662(b) (6) and 6662(i). Specifically, the Service has removed the requirement that examiners follow the four-step process, including obtaining executive-level approval by the examiner’s territory manager and the DFO. Instead, LB&I or SB/SE examiners need only obtain approval from their immediate supervisor to assert a penalty under the economic substance doctrine.
The memorandum also removes the list of transactions for which the economic substance doctrine is likely not appropriate and eliminates the requirement that the taxpayer be notified that the examiner is considering applying the economic substance doctrine. (LB&I senior officials have confirmed, however, that providing taxpayers with notice would be considered a best practice even if no longer formally required.)
The only long-standing requirements that remain in place are the requirement under Sec. 6751(b) that penalties be timely approved in writing by the immediate supervisor of the person who initially determines the penalty, and the mandatory involvement of Counsel. In addition, Attachment 1 to the April 2022 memorandum lists facts and circumstances that tend to show that application of the economic substance doctrine may be appropriate, much like the former guidance for Step 2.
While the memorandum states that "the changes set forth herein align this penalty with other assessable penalties which do not require executive approval," no "assessable penalties" are discussed, and no distinction is made between penalties for which reasonable cause may be asserted and the strict-liability penalty imposed by Secs. 6662(b)(6) and 6662(i).
In another departure from previous guidance, Attachment 1 to the April 2022 memorandum provides that other judicial doctrines can be considered in addition to the economic substance doctrine, stating:
The economic substance doctrine may be applied in addition to other judicial doctrines (e.g., substance over form or step transaction) either as a primary argument or as an alternative position to those judicial doctrines depending on the facts and circumstances of the case. Likewise, if recharacterizing a transaction (e.g., recharacterizing debt as equity, recharacterizing someone as an agent of another, recharacterizing a partnership interest as another kind of interest, or recharacterizing a collection of financial products as another kind of interest) addresses the noncompliance that is being examined, then recharacterization should be applied and the economic substance doctrine may be considered as either a primary or alternative position based on the facts and circumstances of the case.
This guidance is directly contradictory to the inquiries previously required in Step 3 of IRM Section 4. 46.4-4, which demonstrated a preference for applying other judicial doctrines or recharacterizing a transaction where appropriate rather than applying the economic substance doctrine.
LB&I senior officials have confirmed that examiners are free to look at all legal arguments and all facts and circumstances when deciding whether to impose a penalty under the economic substance doctrine and that there is no longer a list of transactions that are ''safe.'' The only carve-out mirrors previous guidance regarding transactions that are consistent with congressional intent, stating:
Notwithstanding existence of the above facts and circumstances, the economic substance doctrine may not be appropriate if the transaction that generates targeted tax incentives is, in form and substance, consistent with Congressional intent in providing the incentives.
Practical tips
- Documentation of the economic substance and business purpose of a transaction and any key steps in the transaction that produce a tax benefit is especially important.
- While the process for an examiner to assess a penalty under Secs. 6662(b)(6) and 6662(i) has changed, taxpayers that can demonstrate that the transaction at issue complies with congressional intent may still be afforded some protection from the imposition of a penalty under the economic substance doctrine.
- While the Service has concluded that the four-step process, including DFO approval, is no longer needed, taxpayers should be mindful that newer examiners and Counsel team members with less experience in applying the economic substance doctrine may require additional information and documentation.
Contributors
Regina Clark, J.D., is a director in PwC LLP’s Tax Controversy and Regulatory Services group in Washington, D.C., and a member of the AICPA Tax Practice and Procedures Committee. Gloria Sullivan is a managing director in PwC LLP’s Tax Controversy and Regulatory Services group in San Francisco. Sullivan previously spent 37 years in tax administration at the IRS, including 20 years of LB&I leadership and seven years of executive leadership. For more information about this column, contact thetaxadviser@aicpa.org.
