In Notice 2014-58, the IRS provided guidance on the codification of the economic substance doctrine under section 7701(o) of the Code and related penalties. In particular, the notice defined the term “transaction” for purposes of applying section 7701(o) and explained the meaning of “similar rule of law” as described in the accuracy-related penalty under section 6662(b)(6).

The codified economic substance doctrine tests whether a “transaction” has economic substance within the meaning of section 7701(o)(1), but the Code does not define the term “transaction” for this purpose. Section 7701(o)(5)(D) provides that the term transaction includes a series of transactions, and the legislative history to section 7701(o) explains that the provision does not alter the court’s ability to aggregate, disaggregate or otherwise recharacterize a transaction when applying the economic substance doctrine. The notice applies the definition of “transaction” from the analogous context of reportable transactions to section 7701(o). That is, for purposes of determining whether the codified economic substance doctrine applies, the term “‘transaction’ generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan or arrangement and any or all of the steps that are carried out as part of a plan.” 

Furthermore, the notice clarifies that facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction. The notice states that, generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objection, the “transaction” includes all the steps taken together. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, this “aggregation approach” may not be appropriate, and the “transaction” may include only the tax-motivated steps that are necessary to accomplish the non-tax goals – a “disaggregation approach.”

Section 6662(b)(6) imposes a penalty on an underpayment of tax attributable to tax benefits that were disallowed because a transaction lacked economic substance within the meaning of section 7701(o) or failed to meet the requirements of any “similar rule of law.” Neither section 7701(o) or 6662(b)(6) define “similar rule of law.” The notice follows language from the legislative history and states that “‘similar rule of law’ means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis, even if a different term or terms (for example, ‘sham transaction doctrine’) are used to describe the rule or doctrine.” The notice also clarifies that the IRS will not apply a penalty under section 6662(b)(6) (or otherwise argue that a transaction is described in section 6662(b)(6)) unless it also raises section 7701(o) to support the underlying adjustments. If the IRS instead relies on other judicial doctrines to support the underlying adjustments (e.g., the substance over form or step transaction doctrines), the IRS will not apply a section 6662(b)(6) penalty (or otherwise argue that a transaction is described in section 6662(b)(6)) because the IRS will not treat the transaction as failing to meet the requirements of a similar rule of law. The notice clarifies that Code sections and Treasury regulations, other than section 7701(o) and the regulations thereunder, that disallow tax benefits are not similar rules of law for purposes of section 6662(b)(6).

The notice also states that it is relevant with respect to the availability of the reasonable cause exceptions under sections 6664(c) and (d) and the reasonable basis exception under section 6676, because these exceptions are inapplicable to transactions described in section 6662(b)(6).