On April 3, 2012, the IRS issued Chief Counsel Notice 2012-008, which prescribes coordination procedures for applying the economic substance doctrine and related penalties. The purpose of the notice is to limit application of the common law or codified economic substance doctrine and related penalties to “appropriate cases.”
The notice includes three key items: (1) instructions regarding IRS Chief Counsel’s role during an audit that involves the application of the economic substance doctrine under the common law or as codified in Internal Revenue Code section 7701(o), including related penalties; (2) instructions for reviewing a statutory notice of deficiency or a notice of final partnership administration adjustment if it is concluded that a transaction lacks economic substance; and (3) coordination procedures for litigating the economic substance doctrine, including any related penalties.
As a threshold matter, the notice directs the IRS to consider all substantive arguments and technical analyses reasonably relevant to the tax treatment of the transaction before applying the economic substance doctrine. Neither the common law nor codified economic substance doctrine should change how the IRS analyzes the tax treatment of a transaction under the Internal Revenue Code, Treasury Regulations, and other applicable law.
Procedures Governing IRS Audits, Statutory Notices of Deficiency and Notices of Final Partnership Administrative Adjustment
If requested to provide advice during an audit, IRS Chief Counsel is required by Chief Counsel Notice 2012-008 to provide timely assistance regarding the application of the economic substance doctrine and related penalties. Any advice provided by IRS Chief Counsel should generally take into consideration the relevant factors set forth in previous Large Business & International Division directives, as well as relevant case law. Although the directives address the economic substance doctrine as codified, IRS Chief Counsel should also take the directives into consideration where the common law economic substance doctrine alone applies.
Where the transaction at issue is the subject of a private letter ruling favorable to the taxpayer, the ruling (or any favorable determination letter issued to the taxpayer) should be reviewed and, if appropriate, revoked. Before proposing any adjustments to the transaction consistent with the economic substance doctrine, the IRS should first confirm that the ruling (or determination letter) has been, in fact, revoked. These procedures apply even where the private letter ruling does not discuss the economic substance doctrine. Similarly, the IRS should not issue any private letter ruling addressing whether the economic substance doctrine applies to a transaction. 15
Finally, where the underlying transaction is determined to lack economic substance, the IRS audit team should coordinate with Division Counsel and Associate Chief Counsel. Under Chief Counsel Notice 2012-008, the audit team, Division Counsel, and Associate Chief Counsel should work together in proposing a statutory notice of deficiency or a notice of final partnership administrative adjustment.
Before the codified or common law economic substance doctrine and any related penalty is raised in litigation, IRS counsel is generally required by Chief Counsel Notice 2012-008 to coordinate with Division Counsel and the Office of the Associate Chief Counsel (Procedure and Administration).
Consistent with the guidelines governing audits, if the transaction at issue is subject to a favorable private letter ruling, the IRS must request that the Associate Chief Counsel office with jurisdiction over the transaction review and, if appropriate, revoke the applicable private letter ruling. Again, if the IRS revokes the ruling, it must confirm the revocation before raising the economic substance doctrine and related penalties. The IRS must follow these procedures even where the economic substance doctrine is not discussed in the private letter ruling.
Finally, Chief Counsel Notice 2012-008 requires that any brief, court filing or other submission addressing the economic substance doctrine be reviewed by the National Office prior to filing. This requirement applies to ongoing cases to the extent the brief, motion, defense or suit letter, or other court submission has not yet been filed.
In short, Chief Counsel Notice 2012-008 provides instructions to IRS counsel to ensure consistent application of the economic substance doctrine in the context of tax audits and litigation. Although the notice creates no rights for the taxpayer and provides no more guidance than previous Large Business & International Division directives, it will hopefully ensure a coordinated and consistent application of the doctrine.