In a July 15th directive from IRS's Large Business & International (LB&I) Division, IRS issued guidance for managers and examiners on determining when to seek the approval of the Director of Field Operations (DFO) in order to raise the economic substance doctrine. The directive lays out a multi-step analysis for examiners to complete before submitting their requests to the DFO.
Background on economic substance. For transactions entered into after Mar. 30, 2010, and for underpayments, understatements, and refunds and credits attributable to transactions entered into after Mar. 30, 2010, a transaction to which the economic substance doctrine is relevant is treated as having economic substance under a conjunctive two-prong test only if—apart from Federal income tax effects—both:
(1) the transaction changes the taxpayer's economic position in a meaningful way; (Code Sec. 7701(o)(1)(A)) and
(2) the taxpayer has a substantial purpose for entering into the transaction. (Code Sec. 7701(o)(1)(B)) That is, the taxpayer's non-Federal-income-tax purpose for entering into a transaction must be “substantial.”
Background on penalties. For underpayments attributable to transactions entered into after Mar. 30, 2010, a 20% strict liability penalty applies to an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (as defined in Code Sec. 7701(o)), or “failing to meet the requirements of any similar rule of law.” (Code Sec. 6662(b)(6)) The penalty rate is increased to 40% if the taxpayer doesn't adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return. (Code Sec. 6662(i)(1)) Code Sec. 6664 's reasonable cause exception doesn't apply to the Code Sec. 6662(b)(6) penalty. (Code Sec. 6664(c)(2)) Additionally, a maximum 20% strict liability penalty under Code Sec. 6676 applies to refund claims based on any transaction described in Code Sec. 6662(b)(6).
New guidance. The new LB&I directive provides instructions to examiners and their managers on determining when to seek the approval of the DFO in order to raise the economic substance doctrine. This approval was mandated by a prior LB&I directive designed to ensure consistent application of the associated strict liability penalty.
Once an examiner determines that raising the doctrine might be warranted, the directive sets out a series of four steps that the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.
(1) The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely not appropriate. Among the factors indicating that the doctrine is inappropriate are that the transaction is not promoted by a tax department or outside advisors, is not highly structured, is at arm's length with unrelated third parties, and carries a significant risk of loss.
(2) The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely appropriate. These factors include that the transaction includes unnecessary steps, accelerates a loss or duplicates a deduction, has no credible business purpose apart from federal tax benefits, and is outside the taxpayer's ordinary business operations.
(3) The examiner must answer each of the following inquiries before seeking the approval of the appropriate DFO to apply the doctrine. If the answer to (i) through (iv) is affirmative, then application of the doctrine should not be pursued without specific approval of the examiner's manager in consultation with local counsel. In answering (v) and (vi), the examiner should seek the advice of his manager in consultation with local counsel.
(i) Is the transaction a statutory or regulatory election?
(ii) Is the transaction subject to a detailed statutory or regulatory scheme, and if so, does it comply with this scheme?
(iii) Does judicial or administrative precedent exist that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction, or upholds the transaction without reference to the doctrine?
(iv) Does the transaction involve tax credits (e.g., for low-income housing or alternative energy) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?
(v) Does another judicial doctrine more appropriately address the noncompliance that is being examined?
(vi) Does recharacterizing the transaction more appropriately address the noncompliance that is being examined?
(vii) 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, it shouldn't be pursued without specific approval of the examiner's manager in consultation with local counsel.
(4) If an examiner completes the above inquiries and concludes that it is appropriate to seek approval to apply the doctrine, the examiner, in consultation with his manager and territory manager, should describe for the appropriate DFO in writing how the analysis was completed. The DFO should then review the written material provided and consult with counsel. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain their position. The DFO should convey the final decision to the examiner in writing.
Individual steps of multi-step transactions. The directive provided that when a transaction involves a series of interconnected steps with a common objective, the steps are generally viewed together in applying the above guidance. 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, such as when 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 must first seek guidance from their manager and consult with their local counsel.
Taxpayer notification. An examiner should notify a taxpayer that he 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 four-step analysis.
Penalties limited to economic substance doctrine. The directive also clarifies that, until further guidance is provided, the penalties under Code Sec. 6662(b)(6) and Code Sec. 6676 are limited solely to the application of the economic substance doctrine. They may not be imposed due to the application of any other similar “rule of law” or judicial doctrine, like the step transaction doctrine or substance over form.
References: For the Code Sec. 7701(o) economic substance doctrine, see FTC 2d/FIN ¶M-5900; United States Tax Reporter ¶77,014.35; TG ¶17490.