Economic Substance Guidance Issued to IRS Examiners

The IRS Large Business and International (LB&I) Division issued guidance to examiners on the newly codified economic substance doctrine limiting the application of penalties relating to the doctrine (LB&I-4-0711-015).

The Health Care and Education Reconciliation Act of 2010, P.L. 111-152, codified the economic substance doctrine and a related strict liability penalty for transactions entered into after March 30, 2010. The new Sec. 6662(b)(6) strict liability penalty applies to any transaction lacking economic substance under Sec. 7701(o) and “any similar rule of law.” The penalty is 40% if the transaction is undisclosed (Sec. 6662(i)) and 20% if it is adequately disclosed on Form 8275, Disclosure Statement, Form 8275-R, Regulation Disclosure Statement, or Schedule UTP, Uncertain Tax Position Statement, with additional requirements for reportable transactions.

The IRS has said that it does not intend to provide substantive guidance to taxpayers on the codified economic substance doctrine (see Notice 2010-62).

The LB&I directive issued on July 15 tells IRS examiners that, until further guidance is issued, they should apply the penalties in Secs. 6662(b)(6) and (i) and 6676 (governing erroneous claims for refund or credit) only to the economic substance doctrine and may not impose them due 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.

The LB&I directive also instructs IRS examiners how to determine when it is appropriate to seek the approval of the Director of Field Operations (DFO) to raise the economic substance doctrine. This determination will involve four steps:

1. The examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate;
2. The examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction may be appropriate;
3. If the examiner determines that the application of the doctrine may be appropriate, the examiner must make a series of inquiries before seeking approval to apply the doctrine; and
4. If an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, the directive provides how to request DFO approval.

For steps 1 and 2, the directive provides lists of specific circumstances that tend to show that application of the economic substance doctrine is likely not appropriate or may be appropriate, as the case may be. For step 3, it provides specific inquiries the examiner must answer.

The directive clarifies for examiners that, for transactions involving a series of interconnected steps with a common objective, the term “transaction” refers to all of the steps taken together. Examiners can apply the directive separately to one or more steps with a common objective, but must seek guidance from their manager and consult with local IRS counsel before doing so.