Economic Substance Doctrine Is Like Santa Claus

As a result of the Directive recently issued to the field by the Large Business and International (LB&I) Division of the IRS, it is likely that the Economic Substance Doctrine will begin to share a key attribute of Santa Claus: to be more talked about than seen. As such, the Doctrine can play what had come to be its primary role: the in terrorem effect, made much more terrible by the no-fault penalties enacted with Code Section 7701(o). By substantially curtailing the actual assertion of the doctrine to collect revenue, the IRS can hope to avoid the only real threat to the Doctrine — Supreme Court review. In that vein, the IRS must be breathing a sigh of relief that the Court recently refused to review the Doctrine as used to convict attorney Ruble.1 That was likely the best test case for Supreme Court review of the Doctrine any time soon. Thus, the IRS will have an incentive to maintain the Doctrine as a lurking Santa Claus in reverse (the presents are for the fisc and not the taxpayer), while it maintains a low enough profile to avoid creating further cases that the Supreme Court might hear and use to clip Santa’s reindeers’ antlers.

LB&I Directive

On July 15, LB&I issued a Directive to its examiners, managers and others in management about the application of the Doctrine. It explained that it was a follow-up to the Directive issued 10 months earlier, which attempted to ensure a uniform application of the Doctrine (and accompanying penalties) by requiring LB&I examiners to obtain approval by the appropriate Director of Field Operations before proposing to impose the Doctrine in an audit.

Many commentators had questioned the earlier Directive, on various grounds: (1) it applied only to LB&I; (2) there are about 15 DFOs around the country, so it was not clear how they would produce a consistent standard of application (aside from talking to each other); but (3) there would be time to figure these things out, because the codification of the Doctrine and its penalties apply only to postenactment transactions (hence audits are a few years away).

In Notice 2010-62, the IRS purported to provide “interim guidance.” That guidance answered a few procedural questions, but flatly refused to give general or letter ruling guidance on when the Doctrine was “relevant” to a transaction — and numerous IRS/Treasury officials kept to that position in public appearances. Now, 10 months later, LB&I has provided a wealth of guidance, at least to field examiners and their managers concerning audits of taxpayers under LB&I, about when the Doctrine is relevant.

Why the about-face? Of course what the Directive says is more important, but one explanation of the about-face relates to the Santa Claus theory: LB&I figured out that the “tax shelter” wars had largely been won — at least public corporations and other businesses that must undergo financial audits for credit purposes have come to believe in Santa Claus. They have been aided by their financial auditors, who now are the first people to ask, “Does this transaction you are considering violate the economic substance doctrine?” That question is usually enough to head off really questionable ideas, but unfortunately it has created a hurdle for reasonable ideas that have a tax flavor. Some reasonable solution had to be found for honest taxpayers to know what they can and cannot do under the Doctrine and the new Directive goes a long way toward providing that. Whether the financial auditors will follow remains to be seen.

When the Doctrine Is Not Relevant

After swearing adamantly that no safe harbors would be created, IRS, through the Directive, in effect creates these safe harbors from application of the Doctrine:

  • The four safe harbors identified by the Joint Committee Explanation of the bill proposing to codify the Doctrine: (1) choosing to capitalize a business with debt or equity; (2) choosing to use a CFC or not to do business abroad; (3) choosing to enter into a Subchapter C corporate organization or reorganization; and (4) choosing to do a deal with a related party, as long as Section 482 and related Doctrines are observed.
  • The transaction itself is a statutory or regulatory election; that is, checking the box normally should not be subject to attack under the Doctrine.
  • Is the transaction subject towwtailed tax regulatory scheme? One clear example would be a corporate reorganization, which is already safe-harbored above. Others might include anything subject to Subpart F, which is about as complete and complex a regulatory scheme as can be imagined — transactions dependent on the consolidated return regulations; transactions controlled by Section 108; transactions subject to the partnership anti-abuse rules; and now transactions reliant on the stock basis rules of the Section 358 regulations, which have become quite complete.
  • Transactions to which determinations of economic substance or substance over form (i.e., did it really happen) have been applied, as opposed to the Doctrine. An example might be debt determination: Knetsch determined that Mr. Knetsch did not incur debt and did not apply the Doctrine.
  • Tax credits obviously intended by Congress to promote certain activities.

Of course, none of these safe harbors are absolute and the IRS will deny they are properly viewable as safe harbors. Rather, when they exist, the Directive places a lot of hurdles between the examiner and a tax assessment based on the Doctrine. But, the result likely will be about the same as a safe harbor.

Other Rules for Examiners

If the safe harbors were not good enough, the Directive closes by telling the examiner to seek to apply the Doctrine only when it is the strongest and most appropriate argument. This is an amazing change of administrative posture. In the late 1990s and the first decade of this century, it appeared to most practitioners that examiners were encouraged to throw in an argument under the Doctrine at will. Indeed, the Notices by which transactions became “listed transactions” showed examiners the way by laundry listing fact finding grounds, hard-law grounds and the Doctrine, as a ground for killing anything called a “tax shelter.”

No more. Rather, examiners are to search hard for the best arguments and are encouraged to distinguish between the Doctrine and substance over form, which can be called economic substance. This is a victory for good government.

Another big change is that the Directive creates a presumption that all of the steps in a transaction are to be tested, not just one. Sure there is enough flexibility in the Directive to override this presumption, but it is there. Also, examiners are not to assert the Doctrine’s codified penalties when an adjustment is based on similar rules of law until further notice.


Practitioners could not have written a more favorable set of audit guidelines than those in the new LB&I Directive, given where the IRS has come from.