The economic substance doctrine was historically a judicial doctrine. It was codified by the Health Care and Education Reconciliation Act of 2010 in Section7701(o). Although practitioners describe it as a codification, Section 7701(o) is a clarification of how the doctrine is to be applied when a court determines it is relevant. Importantly, Section 6662(b)(6) was also added to the Code to implement Section 7701(o). Section 6662(b)(6) imposes a 20 percent penalty on any underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance. This is a strict liability penalty with no reasonable cause defense and no penalty relief even if a taxpayer receives an opinion on the transaction.1
The doctrine states that a transaction has economic substance if it changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.2 If a transaction lacks economic substance, the tax benefits of the transaction are disallowed and the strict liability penalty applies.
Bifurcation of Steps
There is no official legislative history for Section 7701(o) other than a pamphlet prepared by the Joint Committee on Taxation and a discussion in a report of the Ways and Means Committee. The Joint Committee on Taxation pamphlet points out that a court has the ability to bifurcate the steps of the transaction and independently analyze each step for economic substance, rather than view the transaction as a whole for economic substance. In Coltec Industries, Inc. v. United States, the Court of Appeals for the Federal Circuit demonstrated a court’s ability to bifurcate a transaction in this manner by focusing on only one essential step of a transaction rather than the overall transaction.3
In Coltec, the taxpayer had transferred assets into a subsidiary in exchange for stock and the subsidiary’s assumption of contingent asbestos-related liabilities. The taxpayer then sold the high-basis stock at a large discount that generated a $378.7 million capital loss, and the taxpayer argued that the contingent liabilities had not reduced the basis of the stock. In narrowly defining the transaction at issue as the asset-liability exchange with the subsidiary, the court found the "transaction" to have failed the economic substance doctrine because it lacked business purpose and economic reality.
Section 7701(o) fails to define "transaction." It is unclear whether the IRS can examine only a tax motivated step to determine the overall transaction’s economic substance. The IRS issued Notice 2010-62 laying out interim guidance on Section 7701(o) and the related penalty provision.4 The LMSB and LB&I divisions of the IRS issued two field directives on the application of Section 7701(o) and the related penalty provisions.5 The LB&I directive states that if an examiner wants to bifurcate a transaction in applying Section 7701(o), the examiner must obtain guidance from the manager and local counsel. This gave practitioners a sense of relief that Section 7701(o) would likely not be applied by bifurcating a transaction.
The IRS issued Notice 2014-586 on October 9, 2014, to provide guidance concerning "the definition of ‘transaction’ for purposes of applying the codified economic substance doctrine under Section 7701(o)" and "the meaning of ‘similar rule of law’ as described in the accuracy-related penalty under Section 6662(b)(6)."
Under Section 7701(o)(5)(D), the term "transaction" includes a "series of transactions." The Notice states that the Service’s intention is to not "alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine."7 The Notice states that "facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a Transaction." Generally, the IRS considers a transaction to include all the factual elements relevant to the expected tax treatment of any investment, entity, plan or arrangement, including any or all of the steps that are carried out as part of the plan. In the case of a transaction that generates a tax benefit which involves a series of interconnected steps with a common objective, the Service will generally include all of the steps taken together (an "aggregate") in its analysis of economic substance. When a transaction includes a tax-motivated step that is not necessary to the overarching non-tax objectives, the Service may disaggregate the steps and view the "transaction" as only including the tax-motivated steps not necessary to accomplish the non-tax goals.
Notice 2014-58 hints that the IRS may be able to separate out a tax motivated step in a series to determine whether a transaction lacks economic substance under Section 7701(o). Given the material strict liability penalties that may apply, this is quite disturbing, as complicated multi-step transactions often have steps that are part of tax planning even though the overall transaction is motivated by business reasons. Taxpayers entering into future transactions should keep this in mind, as their external financial audit firm may take a more stringent viewpoint on transactions with a tax-motivated step regardless if a tax opinion is received. The external financial auditors may require companies engaged in multistep transactions to reserve for Section 6662 penalties where they have not in the past as a result of this Notice, as the auditors may believe that the IRS will more likely assess these penalties in the future.