As we reported two issues ago in this publication,1 the “economic substance doctrine” has been codified. New Section 7701(o) provides that any transaction (including a series of transactions) entered into after March 30, 2010 and to which the economic substance doctrine is relevant is treated as having economic substance only if (i) the transaction changes in a meaningful way the taxpayer’s economic position (the objective test), and (ii) the taxpayer has a substantial purpose for entering into such transaction (the subjective test). In addition, a new strict liability penalty of 20% has been introduced for an understatement attributable to a disallowance of claimed tax benefits by reason of a transaction entered into after March 30, 2010 lacking economic substance. The penalty is increased to 40% if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment of the transaction on its tax return or in a statement attached to the return. The IRS issued interim guidance in the form of Notice 2010-62 (the “Notice”) stating how it will apply the new Code provision. Unfortunately, the “guidance” is short on new information. The IRS has indicated it will not issue substantive guidance on the new provision.2
In the Notice, the IRS indicates that it will continue to rely on relevant case law under the common-law economic substance doctrine in applying the above described two-prong test and that it will challenge taxpayers who seek to rely on prior case law holding that a transaction has economic substance if either the objective or the subjective test is met. The IRS states that it does not intend to issue general administrative guidance regarding the type of transactions to which the economic substance doctrine either applies or does not apply (i.e., the IRS does not intend to issue an “angel list”).
Further, if the taxpayer is relying on profit motive, in calculating the net present value of the reasonable expected pre-tax profit, the IRS will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for tax purposes—determined by applying existing relevant case law and other published guidance.3 In this respect, the Notice, like the legislative history, merely restates the language in the economic substance statute, rather than providing any guidance. As provided for in the new Code provision, the IRS intends to issue regulations requiring foreign taxes to be treated as expenses in determining pretax profits in appropriate cases.
Finally, the IRS indicated that it will not issue private letter rulings regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the new Code provision.
Apart from the Notice, the IRS also issued a Directive for Industry Directors pursuant to which it directs IRS field agents to have any strict liability penalties proposed in connection with the economic substance doctrine reviewed and approved by the appropriate Director of Field Operations.