The Large Business and International Division of the Service Issues Directive on Raising the Economic Substance Doctrine
On July 15, 2011 the LB&I issued a directive (LB&I-04-0711-015) for industry directors and field specialists on when it is appropriate to raise the economic substance doctrine. IRM. 20.11, 20.1.5. The directive follows one issued in September 2010 (LMSB-04-0910-024) that advised IRS attorneys of the need to obtain approval from a field operations director before raising the issue.
Section 7701(o) , which was recently added to the Code as part of the Health Care and Education Reconciliation Act of 2010, sets forth a statutory definition of the economic substance doctrine.
The common law doctrine of “economic substance,” which continues to have application despite the enactment of Section 7701(o) , may be summarized as a principle applied by the courts to deny taxpayers tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income taxes. It can be applied where the IRS and, if litigation ensues, the court believes that a transaction and its projected tax consequences, including associated costs and expenses, should be disregarded for tax purposes. underlying transaction or series is without economic substance.
Whether a transaction or series of transactions is “without economic substance” is debatable, as witnessed by the number of cases in which a taxpayer has asserted (presumably in good faith) that there was a real change in his or her economic position independent of federal income tax considerations. A “real change” in “economic position” invariably focuses on whether there is a realistic possibility that the taxpayer will derive a profit from the transaction.
The “business purpose” prong requires that the taxpayer, in entering into the transaction, was motivated by a bona fide business purpose and not simply by tax advantages or savings. The business purpose test involves an inquiry into the subjective motives of the taxpayer to determine whether the taxpayer intended the transaction to serve some useful nontax purpose. In making this determination, some courts bifurcate transactions in which activities with nontax objectives are combined with unrelated activities having only tax-avoidance objectives, resulting in the disallowance of the tax benefits of the overall transaction.
Under the new legislation, Section 6662(b)(6) imposes a penalty equal to 20% of the portion of any underpayment of tax attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty is based on the underpayment attributable to the economic substance failure; it is not imposed on the entire deficiency for the tax year. In determining whether the penalty is applicable, Section 6662(i)(2) provides that amendments or supplements to an already-filed return are not taken into account if the amendment or supplement is filed after the date the taxpayer is first contacted by the IRS regarding the examination of the return (or an earlier date as specified by regulations). The new penalty provisions are effective for transactions entered into after 3/30/2010.
In addition, Section 6662(i) imposes an increase in the accuracy related penalty for nondisclosed noneconomic substance transactions. More specifically, where “any portion of an underpayment is attributable to one or more nondisclosed noneconomic substance transactions,” the accuracy related penalty with respect to that portion climbs to 40% instead. A "nondisclosed noneconomic substance transaction" means any portion of a transaction described in Section 6662(b)(6) with respect to which the relevant facts affecting the tax treatment are neither adequately disclosed in the return nor included in a statement attached to the return. Unless otherwise provided, an amendment or supplement to a return of tax will not be taken into account if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the IRS regarding the examination of the return or another date as is specified by the IRS.
A third principal change made to the accuracy-related penalty rules under the “clarification” of the economic substance doctrine is found in new Section 6664(c)(2) , which provides that the “reasonable cause” exception does not apply to any portion of an underpayment that is attributable one or more transactions described in Section 6662(b)(6) —that is, any transaction lacking economic substance as defined in Section 7701(o).
For background on the judicial doctrines that oversee the tax law such as economic substance, the step transaction doctrine, substance over form, etc. and the recent “clarification” of the economic substance doctrine, See August,“The Codification of the Economic Substance Doctrine, Parts I and II,” Business Entities (WG&L), (Sep/Oct 2010) (Nov/Dec 2010).
There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).There is a fair amount of recent judicial commentary in this area dealing with different forms of tax motivated and tax abusive strategies. For a sampling of relevant case law, see Sala et ux, 106 AFTR 2d 2010-5406 , 2010-2 USTC ¶50527 (CA-10, 2010), rev'g and rem'g 101 AFTR 2d 2008-1843 , 2008-1 USTC ¶50308 , 552 F Supp 2d 1167 (DC Colo., 2008); ACM Partnership, 82 AFTR 2d 98-6682 , 157 F3d 231 , 98-2 USTC ¶50790 (CA-3, 1998), aff'g TC Memo 1997-115 , RIA TC Memo ¶97115 , 73 CCH TCM 2189 , cert. den. 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC, 99 AFTR 2d 2007-850 , 2007-1 USTC ¶50223 , 472 F Supp 2d 885 (DC Texas, 2007), aff'd 103 AFTR 2d 2009-2220 , 568 F3d 537 , 2009-1 USTC ¶50395 (CA-5, 2009); Coltec Industries, Inc., 98 AFTR 2d 2006-5249 , 454 F3d 1340 , 2006-2 USTC ¶50389 (CA-F.C., 2006), vac'g and rem'g 94 AFTR 2d 2004-6708 , 62 Fed Cl 716 , 2004-2 USTC ¶50402 (Fed. Cl. Ct., 2004), cert. den. 127 S. Ct. 1261 (2007); TIFD III-E, Inc. (“Castle Harbor”), 98 AFTR 2d 2006-5616 , 459 F3d 220 , 2006-2 USTC ¶50442 (CA-2, 2006), on remand 104 AFTR 2d 2009-6746 , 2009-2 USTC ¶50676 , 660 F Supp 2d 367 , 2009-2 USTC ¶50711 (DC Conn., 2009); BB&T Corporation, 99 AFTR 2d 2007-376 , 2007-1 USTC ¶50130 (DC N. Car., 2007), aff'd 101 AFTR 2d 2008-1933 , 523 F3d 461 , 2008-1 USTC ¶50306 (CA-4, 2008); Cemco Investors, LLC, 101 AFTR 2d 2008-768 , 515 F3d 749 , 2008-1 USTC ¶50178 (CA-7, 2008).
The Field Directive of July 15, 2011
As mentioned, the recent legislation enacted a two part or conjunctive economic substance test in new section 7701(o). The new statute defines the economic substance doctrine as the common law doctrine under which certain tax benefits are not allowable if the transaction does not have economic substance or lacks a business purpose and states that "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if [the legislation] had never been enacted." The statute further states that "[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if --
(A) first, the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and
(B) second, the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction."
Passage of section 7701(o) resolved the longstanding conflict among various circuit courts of appeal regarding how the doctrine should be applied by codifying a two-part conjunctive test. It applies for transactions entered into and after March 30, 2010, which was the date of enactment of the 2010 Act.
Purpose of the Guidance
On September 14, 2010, an LB&I Directive, LMSB-20-0910-024, was issued relating to the codification of the economic substance doctrine in the 2010 Act. This directive stated that to ensure consistent administration of the strict liability penalty related to the application of the doctrine, any proposal to impose the doctrine (and implicate proposing to set forth the penalty) at IRS exam must be reviewed and approved by the Director of Field Operations (DFO).
The purpose of this LB&I Directive is to instruct examiners and their managers on the circumstances where it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine. Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.
In addition, this LB&I Directive provides, as an important boundary line to LMSB and International, that, until further guidance is issued, the penalties provided in sections 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other "similar rule of law" or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).
This LB&I Directive has four steps. First, an 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. Second, an examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate. Third, if an examiner determines that the application of the doctrine may be appropriate, the guidance provides a series of inquiries an examiner must make before seeking approval to apply the doctrine. Fourth, if an examiner and his or her manager and territory manager determine that application of the economic substance doctrine is merited, guidance is provided on how to request DFO approval.
Generally, in applying this LB&I Directive, when a transaction involves a series of interconnected steps with a common objective, the term "transaction" refers to all of the steps taken together. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps. This may be appropriate in situations where an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner is required to seek guidance from their manager and consult with their local counsel before doing so.
An examiner should notify a taxpayer that the examiner is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the analysis in the steps described below.
The Directive sets forth additional material under each of the four step process to determine if the issue should be raised under section 7701(o).
Many tax practitioners did not feel that it was necessary to codify the economic substance doctrine. Many more practitioners object to the 40% penalty as being too harsh. Perhaps the Service's directive will confirm that LMSB will tread lighly in this area to only go after abusive transactions that are patently obvious.
