It has 5 favorable features:
- Examiners cannot apply the ESD in an examination without first proceeding through a relatively extensive and intensive and multilayered process of analysis involving multiple levels of IRS approval.
- Until further notice the ESD no fault penalties will not apply to “similar rule of law” cases.
- Applying the ESD to all of the steps of an integrated transaction taken together is made the default, and applying it to one or more steps may be limited to steps having only a “minor or incidental relationship” to the transaction, and such application requires consultation with the manager and local counsel.
- The taxpayer will get notice, early and at the end of the LB&I review process, before the ESD is ultimately applied in the examination.
- The Directive, in effect, authorizes what look like a number of “safe harbors,” which are similar to areas mentioned in the Joint Committee Explanation.
The Process. While it may be viewed as standard, workmanlike, IRS procedures, the steps that must be pursued by an examiner to base an adjustment on the ESD likely will appear daunting to all but the most determined examiners. No doubt all of the steps will have to be documented. The steps are as follows:
- First the examiner generates the idea to apply the ESD.
- Second the examiner must evaluate whether application of the ESD is “likely not appropriate.” A checklist of 18 indicators when it is likely not appropriate is provided. The Directive implies that if ALL indicators are present the examiner should stop. If only “some” are present, and the examiner still “believes” the application of the ESD is appropriate, the remaining steps must be followed. The “good” factors include some obvious ones, including (a) passing the ESD two prong test, (b) arm’s length with unrelated parties, (c) transaction is not “pre- packaged.” But the “good” factors include some that may be missing in “good” transactions: (a) transaction was developed or administered by the “tax department,” (b) transaction is “highly structured,” (c) transaction does not accelerate a loss or duplicate a deduction, (d) taxpayer does not hold offsetting positions that reduce risk, (e) transaction is not outside the taxpayer’s normal business operations.
- As part of the second step the examiner also must apply what practitioners will call “safe-harbors” that appeared in the Joint Committee Explanation: (a) choice of capitalizing a business with debt or equity, (b) using a U.S. or foreign corporation to make a foreign investment, (c) doing a corporate organization or reorganization, and (d) using a related party and section 482 pricing. Although the Directive is not entirely clear on this point, if any one of these safe harbors applies it seems that the examiner should stop.
- Step three, which is reached only if none of the four safe harbors apply and not all of the “good” factors apply and the examiner still believes the application of the ESD is appropriate: apply the same 18 factors, minus the one asking whether the taxpayer is seeking a congressionally sanctioned tax incentive, but substituting that the transaction does not have risk, for it having risk, etc. It is hard to see how this step adds much to the process. If the examiner has gotten past step two, it will surely get past step three, but must document it.
- Step four requires the examiner to directly address a separate set of what we can call the second safe harbors, in which application of the ESD cannot be pursued without consultation with manager and local counsel: (a) if “the transaction” is a statutory or regulatory election; (b) the transaction is subject to a detailed statutory or regulatory scheme; (c) precedent upholds the transaction; (d) credits intended to encourage certain transactions; (e) another judicial doctrine “more appropriately” addresses the noncompliance; (f) recharacterization “more appropriately” addresses the noncompliance; (g) the ESD is not “the strongest” argument available to the IRS.
- Step five: If the examiner gets to this point and has approval from the manager and local counsel where needed to go to the DFO and make the case in writing, the DFO must consider that written material and consult with Counsel before giving approval and then must give the taxpayer another chance to disagree in writing or in person.
Significance. Fom the purely practical viewpoint of taxpayer protection, this Directive is great news because it places substantial bureaucratic hurdles between an examiner’s desire to assert the ESD and actual reliance on the ESD to reach an adjustment. It may reflect the IRS’ realization that it has already won the war: the codification of the ESD, plus a string of victories in the last ten years, plus the changed in the roles of financial auditors (who now ask about the ESD early and often), have conspired to make it very difficult for substantial, audited, taxpayers to engage in transactions akin to the “tax shelters” of the 1990s. That leaves real business transactions that have major tax advantaged features, as to which the IRS has little appetite to joust (when was the last litigated case on a reorganization?), at least not using the ESD.
From the good government viewpoint, the Directive is good government indeed. It marks the very first governmental pronouncement in the long and sorry history of this “doctrine” that says the first resort of the government should be to the law, and to legal doctrine long developed and applied in the tax law; that the ESD should bring up the rear, only after all else fails. It makes clear that substance over form and recharacterizing transactions is NOT the ESD, but is what the courts have traditionally known how to do, before the ESD was thought up. Maybe the IRS is going back to its roots.