Press Room: Tax Release

October 23, 2014

New IRS Guidance on the Codified Economic Substance Doctrine

On October 9, 2014, IRS issued Notice 2014-58, providing additional guidance on two aspects of the codified economic substance doctrine, under which an accuracy-related penalty may be imposed when a transaction lacks economic substance or fails to meet the requirements of any similar rule of law. A transaction has economic substance only if the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and the taxpayer also has a substantial non-federal income tax business purpose for entering into the transaction (Sec. 7701(o)).

The Notice states that the term transaction generally includes all of the steps taken together when a plan that generated a tax benefit involves a series of interconnected steps with a common objective.  That is, generally the steps will be aggregated. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, that step may be disaggregated and tested separately for economic substance. As an example of the disaggregation approach, the Notice states that where there are transfers of multiple assets and liabilities and the transfer of a specific asset or assumption of a specific liability was tax-motivated and unnecessary to accomplish a non-tax objective, then the economic substance doctrine may be applied solely to the transfer or assumption of that specific liability. Similarly, the use of an intermediary employed for tax benefits and whose actions or involvement was unnecessary to accomplish an overarching non-tax objective may be tested separately. These examples are intended to be merely illustrative of the disaggregation approach.

In practice, this definition of transaction essentially restates the position IRS has taken in litigation and provides little guidance as to whether a series of steps will be tested as a single transaction or one or more steps will be disaggregated and tested separately. Those issues will continue to be left to the courts to ultimately decide.

The Notice also clarifies that the term similar rule of law, as used in Sec. 6662(b)(6),means a rule or doctrine that applies the same factors or analysis as required for an economic-substance analysis even if a different term is used to describe the rule or doctrine (such as the sham transaction doctrine).  That is, a similar rule of law means a rule or doctrine that disallows tax benefits related to a transaction because the transaction either does not change a taxpayer’s economic position in a meaningful way apart from federal tax effects, or the taxpayer did not have a substantial non-federal income tax business purpose for the transaction. Importantly, IRS will not apply a penalty under Sec. 6662(b)(6) unless it also raises the lack of economic substance to disallow the claimed tax benefits. If it relies instead on other judicial doctrines, such as the substance-over-form or step-transaction doctrines, IRS will not apply a Sec. 6662(b)(6) penalty. IRS had previously taken a similar position in a 2011 LB&I Directive but, unlike that directive, the Notice is binding on IRS.