In an unexpected move, the IRS issued Notice 2014-58 in an attempt to provide taxpayers with much needed guidance on the application of the economic substance doctrine ("ESD") in Code Section 7701(o). While taxpayers have been pleading for guidance on this ambiguous provision, the Notice unfortunately creates more questions than it answers.
The Notice resolves when penalties apply to transactions that lack economic substance; however, the Notice’s insufficient attempt to delineate the “transaction” to which the economic substance doctrine applies creates more questions than it answers.
Similar Rule of Law
Pursuant to section 7701(o), a transaction has economic substance when (1) the transaction changes the taxpayer's economic position and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction. In addition, Code Section 6662(b)(6) imposes a 20 percent penalty on the tax underpayment related to any transaction that lacks economic substance or fails to meet the requirements of “any similar rule of law.” The penalty is increased to 40 percent if a taxpayer does not properly disclose the transaction, and most importantly, a taxpayer cannot rely on the reasonable cause exception to reduce a section 6662(b)(6) penalty. Understandably, the ambiguity of the phrase “any similar rule of law” left many taxpayers fearful as to whether a transaction that lacked “substance” under the step-transaction or substance-over-form doctrines would also be subject to the harsh provisions of section 6662(b)(6).
The Notice provides that the IRS will only assert section 6662(b)(6) penalties when it applies the two-factor analysis in section 7701(o). Thus, the IRS will not apply the section 6662(b)(6) penalty when it relies on the substance-over-form or step-transaction doctrines to recharacterize a transaction.
Defining the Transaction
Any gratitude that taxpayers felt towards the IRS for its clarification of section 6662(b)(6) was quickly extinguished when the IRS “clarified” how it intends to determine a taxpayer’s “transaction” for purposes of applying the economic substance doctrine. As noted above, section 7701(o) provides that a “transaction” has economic substance as long as the “transaction” changes in a meaningful way the taxpayer’s economic position and the taxpayer has a substantial purpose for entering into the “transaction.” Thus, every practitioner knows that one of the keys to winning an ESD dispute is to define the scope of a “transaction” in the most favorable manner.
Regrettably, rather than providing taxpayers or courts with any real guidance as to how the IRS will define the scope of a transaction, the Notice provides that the IRS will define the scope of a transaction based on “facts and circumstances” (i.e., the IRS believes it is free to define the transaction however it wants). Accordingly, the IRS can aggregate a series of “interconnected” transactions so that the IRS applies the ESD to the combined transactions (the “aggregation approach”); on the other hand, the IRS can also disaggregate a single
transaction so that the IRS applies the ESD to a “tax-motivated” step within the transaction that is not necessary to accomplish non-tax goals (the “disaggregation approach”).
The disaggregation approach is based on the holding in Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In essence, it allows the IRS to bifurcate a transaction such that the tax-motivated step is separated from the other steps that give the overall transaction a business purpose.
If the courts had always been allowed to disaggregate a transaction in this manner, many taxpayer favorable ESD cases may have had different outcomes. For example, in Flextronics America v. Commissioner, 499 Fed. Appx. 725 (9th Cir. 2012), the taxpayer transferred the same asset several times among its various subsidiaries in order to get a non-taxable basis increase and “to set up its desired operating structure.” If the court had applied the disaggregation approach in Flextronics, the court may have applied the ESD to the transfer that provided the basis increase and not to the other transfers that allowed the corporation to establish its operating structure. Similarly, the outcome in Shell Petroleum Inc. v. United States, 102 A.F.T.R.2d 5085 (S.D. Tex. 2008) may also have been different. In that case, the taxpayer contributed multiple assets and liabilities to a new entity as part of the same transaction. If the court had applied the disaggregation approach, the court would have analyzed whether each transfer of assets had a valid business purpose. Accordingly, the court may have applied the ESD to the transfer of one of the assets and not to the transfers of the other assets (even though all the transfers were part of the same transaction).
In addition, the IRS’s characterization of the aggregation approach could create headaches for taxpayers. The Notice provides that a series of transactions can be aggregated if the transactions are “interconnected.” In many instances, taxpayers will want to argue that the aggregation approach applies because it is often easier to satisfy the two ESD factors under the aggregation approach. However, by arguing that the more taxpayer-friendly aggregation approach applies to a transaction, a taxpayer may be shooting itself in the foot for step-transaction doctrine purposes. If the step-transaction doctrine also could apply to a transaction, then the taxpayer would have to argue that a series of transactions are “interconnected” for ESD purposes while also arguing that the transactions are not “interdependent” for step-transaction purposes.
Ultimately, the IRS’s approach to defining “transaction” seems to be saying to taxpayers “heads I win, tails you lose.”
The House Report
The Notice also represents the first time that the IRS has referred to The House Ways and Means Report 111-443 (the “House Report”) as legislative history. A great deal of uncertainty exists as to whether the House Report is authoritative legislative history because the House Report was written to accompany a bill that never became law.
While the House Report may create issues for taxpayers (after all, the IRS relied on it as authority for the disaggregation approach), the House Report is enormously helpful to taxpayers in other ways. In particular, the House Report
lists four kinds of transactions to which the ESD does not apply. The House Report provides:
[Section 7701(o)] is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Among these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; (2) a US person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) 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.
This so called “Angel’s List” has been very helpful to taxpayers that are attempting to understand when the ESD is relevant to a transaction. Taxpayers who have been relying on the Angel’s List should find comfort in the fact that the IRS views the House Report as authoritative legislative history.
By John D. Barlow, Washington, DC