Press Room: Tax Release

July 29, 2011

Much Anticipated Guidance on Economic Substance is Here!

The economic substance doctrine allows Internal Revenue Service (IRS) to invalidate any anticipated tax benefits arising from a transaction that does not result in a meaningful change to the taxpayer’s economic position.  A recent internal IRS memorandum reveals when IRS will apply economic substance doctrine under new statutory rules.  Taxpayers should use the memorandum to analyze whether transactions entered into in 2010 will be treated as having economic substance.

Section 7701(o) of the Internal Revenue Code now provides that, in the case of any transaction to which the economic substance doctrine is relevant, the transaction shall be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and (2) the taxpayer has a substantial purpose (apart from federal income tax) for entering into such transaction.  Taxpayers that enter into transactions without economic substance are subject to a strict liability penalty of 20% of the underpayment attributable to the transaction (40% for undisclosed transactions).  Section 7701(o) applies to transactions entered into after March 30, 2010. To calculate the penalty, taxpayers will be required to redetermine their tax liability in accordance with the “true” economic substance of the transaction at issue. 

On July 15, 2011, Heather Maloy, IRS Commissioner (Large Business & International), issued guidance regarding when IRS will pursue economic substance cases.  This guidance explains the proper procedure that examiners and their managers should take before seeking approval of the Director of Field Operations (DFO).  Generally, examiners are to assess whether application of the doctrine is, or is not, appropriate by using a specified list of factors.  If the examiner concludes that it is appropriate to apply the doctrine, a written explanation must be submitted to the DFO for approval to proceed further.

The memorandum also contains a list of transactions that will generally not be treated as subject to the economic substance doctrine including the choice: (1) to capitalize with debt or equity; (2) to use a foreign or domestic entity to make a foreign investment; (3) to enter into a reorganization; or (4) to use a related party in a transaction provided the standards of Section 482 are met. 

Taxpayers and their advisors should review the list of factors contained in the memorandum as they analyze whether the economic substance doctrine may apply.

To view the entire memorandum, go to IRS website by clicking here: “Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties.”

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