As we have previously reported on September 27, 2010 (Six Months Later IRS Issues Only Limited Interim Guidance on Codified Economic Substance Doctrine), the Internal Revenue Service (IRS)1 released a directive (the “2010 Directive”) requiring IRS agents to obtain approval by a Director of Field Operations (DFO) before asserting a 20% or 40% strict liability penalty2 based upon a conclusion that a transaction lacked economic substance. It appears that the IRS intends to continue to provide guidance on the economic substance doctrine through guidelines to auditing agents. On July 12, 2011, the IRS issued another directive3 (the “2011 Directive”) addressing when the codified economic substance doctrine and its associated strict liability penalty could be relevant to a transaction. The 2011 Directive fills in a substantial gap in the implementation of the economic substance doctrine as neither the legislative history of the codified rule nor the statute itself offered any guidance on when the doctrine should be applied.

In addition, the 2011 Directive provides that, until further guidance is issued, the penalties for undertaking a transaction(s) without economic substance should not be asserted for violations of any other “similar rule of law” or judicial doctrine. The 2011 Directive states that the 20% or 40% penalties should not apply to violations of rules that are “kissing cousins” of the economic substance doctrine, such as the step transaction doctrine, recharacterization doctrine, substance over form rule or sham transaction doctrine. This limited application of the economic substance doctrine is welcome news for taxpayers.

The stated purpose of the 2011 Directive is to instruct examiners and their managers on when it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine. The 2011 Directive provides four steps that the examiner must take in order to seek approval of the DFO for the application of the doctrine in an examination.

Background

The codified economic substance doctrine and related penalties are effective for transactions entered into after March 30, 2010. Under the codified doctrine, both objective and subjective prongs must be met for the transaction to be considered to possess economic substance. Specifically, a transaction must (i) change in a meaningful way (apart from the income tax effects) in the taxpayer’s economic position and (ii) be undertaken for a substantial non-income tax purpose.

Nevertheless, as a threshold matter, the Code provides that the IRS or a court must first determine that the economic substance doctrine is “relevant” to a transaction. In other words, if the economic substance doctrine is determined not to be relevant to a particular transaction, the IRS cannot challenge it on the ground that it fails the economic substance test. IRS Notice 2010-62 provided that such a determination should be made in the same manner as if the economic substance doctrine had never been codified. Practitioners have been seeking from Treasury and the IRS specific guidance on what criteria will be used to determine when the doctrine would be considered to be relevant to a transaction.

We are not aware of a single case concluding that the common law test was relevant or not relevant to a disputed transaction. Instead, the cases generally discuss the doctrine only because the court has concluded that it is relevant. Notice 2010-62 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.” Thus, Notice 2010-62 said there will be no “angel list,” “black list,” or “grey list” of transactions.

The 2011 Directive

The Four Steps

The 2011 Directive provides for four steps that the examiner must take in determining whether the economic substance doctrine is relevant to a transaction. First, the examiner should examine a transaction in light of 18 enumerated factors that would suggest that the economic substance doctrine to a transaction is likely not appropriate.

Second, if the case does not involve any of the enumerated step-one factors, the examiner should move to the next step and evaluate whether any of 17 enumerated facts and circumstances are presented which suggest that the economic substance doctrine may be appropriate. (These factors are mirrors of the factors used to determine when the economic substance doctrine is not appropriate.)

Third, if an examiner determines that the application of the doctrine may be appropriate under the second step, the 2011 Directive provides for a further a series of inquiries that the examiner (in consultation with his/her manager and local IRS counsel) must make before seeking approval from the DFO. Before seeking approval of the DFO, the examiner must seek the involvement of his/her manager and territory manager, and when they are both in agreement that the application of the economic substance doctrine is merited, the 2011 Directive provides guidance on how to request the DFO approval.

Finally, an examiner must notify the taxpayer that s/he is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, no later than when the examiner begins the four-step analysis.

The Scope of the ‘Transaction’ at Issue

The 2011 Directive clarifies that when a transaction involves a series of interconnected steps with a common objective, the term “transaction” should include all of the steps taken together. However, in certain circumstances, the 2011 Directive provides that it may be appropriate to apply the 2011 Directive separately to one or more steps that are included within a series of arguably interconnected steps.4 The 2011 Directive clarifies that such a “bifurcation” approach may be appropriate in situations where an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction.

Step 1: Doctrine Likely NOT Appropriate

The IRS listed the following facts and circumstances as tending to show that the application of the economic substance doctrine to a disputed transaction is likely not appropriate:

  • Transaction is not promoted/developed/administered by tax department or outside advisors;
  • Transaction is not highly structured;
  • Transaction contains no unnecessary steps;
  • Transaction that generates targeted tax incentives is, in form and substance, consistent with Congressional intent in providing the incentives;
  • Transaction is at arm’s length with unrelated third parties;
  • Transaction creates a meaningful economic change on a present value basis (pre-tax);
  • Taxpayer’s potential for gain or loss is not artificially limited;
  • Transaction does not accelerate a loss or duplicate a deduction;
  • Transaction does not generate a deduction that is not matched by an equivalent economic loss or expense  (including artificial creation or increase in basis of an asset);
  • Taxpayer does not hold offsetting positions that largely reduce or eliminate the economic risk of the transaction;
  • Transaction does not involve a tax-indifferent counterparty that recognizes substantial income;
  • Transaction does not result in the separation of income recognition from a related deduction either between
  • different taxpayers or between the same taxpayer in different tax years;
  • Transaction has credible business purpose apart from federal tax benefits;
  • Transaction has meaningful potential for profit apart from tax benefits;
  • Transaction has significant risk of loss;
  • Tax benefit is not artificially generated by the transaction;
  • Transaction is not pre-packaged; and
  • Transaction is not outside the taxpayer’s ordinary business operations.

Nevertheless, the 2011 Directive provides that even if “some” of the step-one factors apply to the disputed transaction, the examiner may still consider the application of the doctrine to be appropriate, and s/he may continue to analyze the transaction under Steps 2-4. In addition, the IRS provided a list of “safe harbor” transactions for which it is likely not appropriate to raise the economic substance doctrine. As set forth in the Notice and legislative history of the codified doctrine, these safe harbors include:

  • The choice between capitalizing a business enterprise with debt or equity;
  • A U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment;
  • The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and
  • The choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied.

Step 2: Doctrine May be Appropriate

If the above step-one factors do not support the conclusion that the economic substance doctrine is inappropriate to a transaction, or even if one or more of the above factors exist but the examiner believes that the economic substance doctrine should apply, the examiner must move to step 2. This step provides a mirror list of facts and circumstances that tend to show that the application of the economic substance doctrine may be appropriate. For example, if the transaction is promoted by a tax department or outside advisors or is highly structured, it will be a candidate for surviving the application of the economic substance doctrine.

In contrast to the first step, where the examiner could decide to move to the next step even if the step-one factors suggest that the economic substance doctrine is not relevant, the 2011 Directive is silent as to the examiner’s authority not to move to an approval even if one or more of the step-two factors exist. There is nothing that indicates that the auditor is mandated to move forward if they exist, but there is also no indication on how flexible the examiner can be and whether s/he must move forward to step 3 if s/he finds one of the step-two factors.

Step 3: Development of Case for Approval

If after applying the above two steps the examiner believes that the application of the economic substance doctrine may be appropriate to the disputed transaction s/he must move forward to the third step and answer the following series of inquiries before seeking the approval of his or her appropriate DFO to apply the doctrine:

  • Is the transaction a statutory or regulatory election (e.g., check-the-box)?
  • Is the transaction subject to a detailed statutory or regulatory scheme? If so, does the transaction comply with this scheme?
  • Does precedent exist (judicial or administrative) that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction or upholds the transaction and makes no reference to the doctrine when considering the transaction?
  • Does the transaction involve tax credits (e.g., low income housing credit, alternative energy credits) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?
  • Does another judicial doctrine (e.g., substance over form or step transaction) more appropriately address the noncompliance that is being examined? If so, those doctrines should be applied and not the economic substance doctrine;5
  • Does recharacterizing a transaction (e.g., recharacterizing debt as equity, recharacterizing someone as an agent of another, recharacterizing a partnership interest as another kind of interest, or recharacterizing a collection of financial products as another kind of interest) more appropriately address the transaction that is being examined? If so, recharacterization should be applied and not the economic substance doctrine; and
  • In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available?

If any of these facts and circumstances is present, then the application of the doctrine should not be pursued without specific approval of the examiner’s manager in consultation with local counsel. Thus, step 3 is not conducted solely by the examiner; it involves the examiner’s manager and requires consultation with a local IRS counsel. At this point, these questions will generally assist the examiner in deciding if the dispute at issue can be resolved without applying the economic substance doctrine.

Step 4: DFO Approval

If an examiner completes first three steps, and to the extent necessary, consulted with his/her manager and local counsel, and concludes that it is appropriate to seek approval for the application of the economic substance doctrine, the examiner, in consultation with his or her manager and territory manager, should describe for the appropriate DFO in writing how the four-step analysis was completed.

The DFO, on his/her end, in considering an examiner’s request for approval should review the written material provided and consult with an IRS counsel before a decision is made. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain his/her position, either in writing or in person (at the DFO’s discretion), addressing whether the doctrine should be applied to a particular transaction. Once the DFO has made a final decision, that decision should be conveyed to the examiner in writing.

Conclusions

The 2011 Directive is a serious attempt to provide IRS examiners with specific guidance on how to determine if a disputed transaction should be challenged based on the economic substance doctrine or not. The 2011 Directive also ensures that such decisions will not be made by a single person; it provides for a decision going up the “chain of command” until a decision is made to challenge on economic substance grounds. This provides taxpayers some assurance that thoughtful process has been conducted on this matter.