On September 13, 2010, the Internal Revenue Service (IRS) issued Notice 2010-62 (the “Notice”), providing interim guidance on the application of the codified economic substance doctrine and related penalty provisions.1 On September 14, 2010, Large and Mid Size Business (LMSB) Division Commissioner Heather Malloy issued a Directive for Industry Directors regarding the same law changes (“The Directive”). Since the law’s passage, practitioners have been seeking from Treasury and the IRS specific guidance on how these laws apply to taxpayers. While any guidance is better than no guidance, the Notice largely repeats the statutory language, providing little insight into how the IRS will apply Section 7701(o). The Directive seeks to reassure LMSB taxpayers that assertions of penalties for violations of Section 7701(o) will be coordinated and approved by its management. While the extent of guidance is disappointing to most, exploring what IRS is saying in the Notice and the Directive is both necessary and worthwhile.
The Notice provides guidance on these aspects of section 7701(o): (i) the Application of the Conjunctive Test; (ii) the Determination of Economic Substance Transactions; (iii) Calculating Net Present Value of the Reasonably Expected Tax Profit; and (iv) the Treatment of Foreign Taxes. The Notice also provides guidance regarding adequate disclosure under Section 6662(i).
Application of the Conjunctive Test
The Notice simply repeats the new statutory requirement that both prongs of the codified doctrine must be now be met. Those prongs are: (i) the change in a meaningful way (apart from the income tax effects) in the taxpayer’s economic position (Section 7701(o)(1)(A)) and (b) the substantial non-income tax purpose for the transaction (Section 7701(o)(1)(B)). It comes as no surprise that IRS will challenge transactions under the law that only satisfy either, but not both, of these criteria. As the Notice acknowledges, the new law “mandates the use of a conjunctive two-prong test.”
While the judicial doctrine has a long history, the modern era probably begins with the Supreme Court’s description of economic substance as having business realities and significant non-tax-avoidance features and considerations in Frank Lyon v. U.S., 435 U.S. 561 (1978). Perhaps because the taxpayer in that case prevailed, courts formulated different interpretations of the judicial economic substance doctrine.
Compare Rice’s Toyota Word. Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985) (requiring lack of non-tax economic impact and tax avoidance motive) with Klamath Strategic Investment Fund v. United States, 568 F3d. 537 (5th Cir. 2009) (concluding lack of economic substance sufficient regardless of motive other than tax avoidance). Under codified economic substance, each of the above-stated two prongs must be satisfied. That much is clear. But the key concepts of “meaningful” change or “substantial” purpose are undefined. Many tax shelter cases evaluated the profit potential of the transaction, which differs from a meaningful change. The new law permits, but does not require a pre-tax profit potential. Guidance on the meaning of these terms, which was not provided in the Notice, is needed.
The Notice advises that IRS will rely on case law interpreting the common law doctrine to satisfy each prong. Thus, in determining whether a transaction sufficiently affects the taxpayer’s economic position, the IRS stated that it will apply cases that have dealt with the issue whether the tax benefits of a transaction were not allowable because the transaction did not satisfy the objective prong of the economic substance doctrine. Because courts have evaluated the objective economic substance test differently, reliance on this precedent could permit different results in different courts. Compare Andantech L.L.C. v. Comm’r., T.C. Memo 2002-97, at 106 (“In order to maintain this objectivity and ensure the steps have independent significance, it is useful to compare the transactions in question with those usually expected to occur in otherwise bona fide business settings”) with Goldstein v. Comm’r., 364 F.2d 734 (2nd Cir. 1966) (applying a pretax potential profit analysis to deny interest deduction on tax-motivated loan).
The Notice also repeats the codified principle found in Section 7701(o)(5)(C) that determination of whether the economic substance doctrine is “relevant” to a transaction is made in the same manner as if section 7701(o) had never been enacted. This provision should help prevent attempts to apply the new law where the tax law has long been understood to sanction tax benefits regardless of the transaction’s business purpose. While the Notice then states that authorities finding that the economic substance doctrine “was not relevant to whether certain tax benefits are allowable” will still be followed. We, however, are not aware of a single case concluding that the common law test was not relevant. Instead, the cases generally discuss the doctrine only because the court has concluded that it is relevant. The Notice could have taken the opportunity to emphasize Section 7701(o)(5)(c) as a gatekeeper that the Service will observe in deciding where to invoke the new law. Instead the Notice refers vaguely to case law that “will continue to develop” on the relevance of the economic substance doctrine. If no case law has concluded that the doctrine is not relevant, the developments that the Service expects are unclear. One can only hope that the Service, by looking to the case law it may have in mind, will not fail to cite Section 7701(o)(5)(c) in clarifying where the codified doctrine will not apply.
Predictably but nonetheless unfortunately, the Notice also stated that Treasury and the IRS “do not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply.” Apparently no only will there be no “angel list,” “black list,” or “grey list,” we should not expect any general principles articulated in the administration of this new anti-abuse rule. The lack of safe harbors, in particular, is disappointing, because the Joint Committee on Taxation report that accompanies the new law stated a general intention not to affect long standing tax treatment of certain transactions but also gave examples in a “nonexclusive list.” Coupled with the Notice’s announcement that there will also be no private letter rulings or determination letters on the relevance of the doctrine to a transaction or a transaction’s compliance with the doctrine, the Service is promising no direction or pre-transaction advice about any issue that may arise under the new law. Considering the numerous uncertainties that exist about how the law will be applied, the failure of the Notice to say more may only heighten the misgivings taxpayers and advisors have about the circumstances under which they must consider it.
The Profit Test
Section 7701(o)(2)(A) provides that a transaction’s potential for profit will be taken into account in determining whether the requirements of section 7701(o)(1) are met only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the claimed net tax benefits. This heightened standard was only applied by courts in a handful of cases (such as Long Term Capital Holding), and in some other cases, the courts have recognized that any profit will suffice. The Notice clarifies that if a taxpayer relies on the profit potential to substantiate that the transaction had economic substance and business purpose, 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 Federal income tax purposes. There is no definition or quantitative guidance for what constitutes “substantial” for this purpose. In performing this calculation, the Notice states that the IRS will apply existing relevant case law and other published guidance. The case law prior to the codification, however, was far from being clear.
For purposes of computing pre-tax profit, section 7701(o)(2)(B) provides that the Secretary shall issue regulations treating foreign taxes as a pre-tax expense in appropriate cases, a legislative overruling of the decisions in Compaq, 113 T.C. 214 (1999), rev’d 277 F.3d 778 (5th Cir. 2001) and IES, 253 F.3d 350 (8th Cir. 2001), aff’g in part & rem’g in part 1999 U.S. Dist. LEXIS 22610 (1999). In the interim, in the absence of regulations, the Notice provides that the codification does not restrict the ability of the courts to consider the appropriate treatment of foreign taxes in economic substance cases. Thus, it appears that the Notice concedes that unless and until such regulations are issued, Compaq and IES still remain good law.
The Act introduced and revised penalties. Specifically, the Act added section 6662(b)(6), which provides that the penalty imposed under section 6662(a) would apply to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance or failing to meet any similar rule of law (“Section 6662(b)(6) Transactions. The Act also added section 6662(i), which increases the accuracy-related penalty from 20 to 40 percent for any underpayment attributable to one or more Section 6662(b)(6) Transactions that are not adequately disclosed in the taxpayer’s return or in a statement attached to the return.
In addition, section 6664(c) was amended to provide that the “reasonable cause” exception for underpayments found in section 6664(c)(1). The Act similarly amended section 6664(d) to provide that the reasonable cause exception will not apply to any “reportable transaction understatement” (within the meaning of section 6662A(b)) attributable to a Section 6662(b)(6) Transaction. Finally, the Act amended section 6676 so that any excessive amount (within the meaning of section 6676(b)) attributable to a Section 6662(b)(6) Transaction will not be treated as having a reasonable basis. Thus, the penalty for violations of the codified economic substance doctrine is not subject to the usual defenses for accuracy related penalties, i.e., it is a “strict liability” penalty.
The Directive instructed LMSB Industry Directors that any proposed penalty under Section 6662(b)(6) must be reviewed and approved by the appropriate Director of Field operations.
The Notice focused on the reporting requirement. Unless the challenged transaction is a “reportable transaction,” as defined in Treas. Reg. § 1.6011-4(b), the disclosure requirements of section 6662(i) will be satisfied if the taxpayer adequately discloses on a timely return or a qualified amended return the relevant facts affecting the tax treatment of the transaction. For this purpose, if a disclosure would be considered adequate for purposes of section 6662(d)(2)(B) it will be deemed to be adequate for purposes of section 6662(i). The Notice emphasizes that disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS consistent with the instructions and other guidance associated with those subsequent forms, publications, or other guidance. Importantly disclosures made consistent with the terms of Rev. Proc. 94-69 also will be taken into account for purposes of section 6662(i). The IRS invited comments on this issue.
The Notice and the Directive were issued on consecutive days and deliver a message that the IRS and Treasury intend to administer Section 7701(o) on a case-by-case basis taking into account the common law of the economic substance doctrine but that the assertion of the strict liability penalty will be coordinated and reviewed. We can only hope that future guidance will be forthcoming and more complete.