In a highly anticipated directive released July 15, 2011 (LB&I-4-0711-015) (the “Directive”), the Internal Revenue Service (the “Service”) sets forth a four-step process that examiners and managers must follow before elevating matters for approval to the appropriate Director of Field Operations (“DFO”) to raise the codified economic substance doctrine and its associated strict liability penalty.

The Directive follows an earlier announcement issued in September 2010 (LMSB-20-0910-024), which mandated DFO approval before examination could raise the economic substance doctrine. Although the four-step process suggests that a robust analysis will be required before a case should be elevated, only time will tell whether the Directive will ensure that the economic substance doctrine and associated penalty are administered consistently and fairly.

The Directive and its predecessor follow the enactment of the Health Care and Education Reconciliation Act of 2010, which codified the economic substance doctrine in section 7701(o) of the Internal Revenue Code. In addition, that act added subsections 6662(b)(6) and 6662(i), which impose strict liability penalties of 20 to 40 percent of any underpayment attributable to the disallowance of claimed tax benefits due to the application of the economic substance doctrine or failure to meet the requirements of any “similar rule of law.”

The Directive requires examiners to work through a four-step analysis with their managers before seeking DFO approval to raise the economic substance doctrine and its associated penalty.

First, an examiner should evaluate the facts and circumstances surrounding the matter in determining whether the application of the doctrine to a transaction is likely not appropriate. Factors identified by the Directive for this step include, among others, transactions within the taxpayer’s ordinary business operations and transactions involving a choice between capitalizing a business enterprise with debt or equity or between using a foreign corporation or a domestic corporation to make a foreign investment.

Second, the examiner should evaluate whether the facts and circumstances indicate that the application of the doctrine to the transaction may be appropriate.

Many factors identified in the second step are the direct opposite of the factors identified in the first step. For example, if a transaction contains no additional steps, the doctrine may not be applicable (step one), but the presence of additional steps shows that it may be applicable (step two). Unfortunately, the Directive fails to instruct examiners in determining whether the doctrine is applicable when there are factors indicating both that the doctrine may be applicable and that it may not be applicable. Many of the factors are also very broad, which may result in the unintended consequence of everyday tax planning being flagged as transactions in which it may be appropriate to raise the doctrine. For instance, this may arise when a transaction: (i) is promoted or administered by a tax department or by outside advisors, (ii) accelerates a loss or duplicates a deduction, (iii) involves non-arm’s-length dealings, or (iv) does not result in a meaningful economic change on a present value basis (pre-tax).

Third, if it is determined that the application of the doctrine may be appropriate after the first two steps, the examiner must answer a specified series of questions before elevating the case. These questions include whether the transaction is subject to a detailed statutory or regulatory scheme and whether a judicial doctrine other than the economic substance doctrine would address the noncompliance being examined.

Fourth, if an examiner, her manager and a territory manager collectively determine that application of the economic substance doctrine is merited after these steps are completed, then, and only then, should the appropriate DFO be contacted for approval. In seeking approval, the examiner must submit a written analysis of the first three steps. If the DFO believes it is appropriate to approve the request, the taxpayer must then be given an opportunity to explain its position, in writing or in person, addressing whether the doctrine should be applied to the transaction. The DFO will convey its final decision to the examiner in writing.

An examiner who intends to apply this process to one or more steps of a transaction is required to seek guidance from her manager and consult with local counsel before doing so. 

Until further guidance is issued, the strict liability penalties are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other “similar rule of law” or judicial doctrine.

The Directive leaves many uncertainties over its application, such as the weight afforded to the steps and factors identified, the breadth of the factors and whether the Service will rigorously follow the process identified before raising the economic substance doctrine. That said, however, the Directive’s deliberative process suggests that the Service intends to exercise restraint before the economic substance doctrine and its associated penalty are asserted in examinations. In particular, significant restraint is demonstrated by the Directive instructing examiners to not impose strict liability penalties related to the application of any “similar rule of law,” and the requirement that DFO approval is necessary to raise the doctrine. Nevertheless, the Directive signals the Service’s dedication to pursuing cases where it feels application of the doctrine may be appropriate.