Under newly enacted 7701(o), This newly issued Notice provides interim guidance regarding the codification of the economic substance doctrine, for any transaction to which the economic substance doctrine is relevant, the transaction shall be treated as having economic only in instances where: (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.
Section 7701(o)(5)(A) defines the “economic substance doctrine” as the common law doctrine under which income tax benefits (as well as corresponding costs) with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Both tests have to be met.
Section 7701(o)(5)(C) states that the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if section 7701(o) had never been enacted. With respect to individuals, however, section 7701(o)(5)(B) states that the two-prong analysis in section 7701(o)(1) applies only with respect to a transaction entered in as part of a trade or business or an activity engaged in for the production of income. Transaction, per §7701(o)(5)(D), includes a series of transactions.
Section 7701(o)(2)(A) provides that a transaction’s potential for profit shall be taken into account in determining whether the requirements of section 7701(o)(1) are met only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the claimed net tax benefits. For purposes of computing pre-tax profit, §7701(o)(2)(B) provides that the Secretary shall issue regulations treating foreign taxes as a pre-tax expense in appropriate cases.
The Act also added §6662(b)(6), which provides that the accuracy-related penalty imposed under §6662 (a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of §7701(o)) or failing to meet any similar rule of law (collectively a § 6662(b)(6) transaction). The Act also added section 6662(i), that increases the accuracy related penalty from 20% to 40% for any portion of an underpayment that is attributable to one or more §6662(b)(6) transactions which were not adequately disclosed on the return or statement attached to the return. In addition, §6662(i)(3), also a new provision, provides that certain amended returns or any supplement to a return shall not be taken into consideration for purposes of section 6662 (i).
The Act amended §6664(c) so that the reasonable cause exception for underpayments found in §6664(c) (1) shall not apply to any portion of any underpayment attributable to a § 6662(b)(6) transaction. The Act similarly amended §6664(d) so that the reasonable cause exception found in § 6664(d)(1) shall not apply to any reportable transaction understatement (within the meaning of §6662A(b)) attributable to a § 6662(b)(6) transaction. The Act further revised §6676 so that any excessive amount (within the meaning of §6676(b)) attributable to any §6662(b)(6) transaction shall not be treated as having a reasonable basis.
After providing a summary of the new “clarification” of the economic substance test, the Notice states that for transactions entered into on or after March 31, 2010, the IRS will apply §7701(o)’s two-prong conjunctive test. In determining whether a transaction has a sufficient nontax purpose to satisfy the requirements of §7701(o)(1)(B), the Service announced that it will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose. The Service will therefore challenge transactions where the taxpayer asserts that either the business purpose test or economic tests are applicable.
As a second guideline, Notice 2010-62 provides that the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of §7701(o). Therefore, if legal authorities, prior to the enactment of §7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable. The IRS anticipates that the case law regarding the circumstances in which the economic substancedoctrine is relevant will continue to develop. Consistent with §7701(o)(5)(C), codification of the economic substance doctrine should not affect the ongoingdevelopment of authorities on this issue.
Third, Notice 2010-62 states that the Treasury Department and the IRS do not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply. Inotherwords, there will be no “angel list” of approved transactions as many tax professionals had hoped for.
Fourth, in calculating the net present value of the reasonable expected pre-tax profit under §§7701(o)(1) (A) and (B), the IRS will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for Federal income tax purposes. In performing this calculation, the IRS will apply existing relevant case law and other published guidance. Query, however, what is the discounted rate in computing present value, and what costs are allowable as directly related?
Fifth, Notice 2010-62 restates that §7701(o)(2)(B) grants the Secretary with authority to issue regulations requiring foreign taxes to be treated as expenses in computing the pre-tax profit in certain appropriate instances. Until such regulations are issued, the Notice states that §7701(o) does not restrict the ability of the courts to consider the appropriate treatment of foreign taxes in economic substance cases.
Sixth, as to disclosure issues, the Notice declares that unless a transaction is a reportable transaction per Treas. Reg. §1.6011-4(b), the adequate disclosure requirements of §6662(i) will be met where disclosure is made on a timely filed original return (determined with regard to extensions) or a qualified amended return (as defined under Treas. Reg. § 1.6664-2(c)(3)) the relevant facts affecting the tax treatment of the transaction. If a disclosure would be considered adequate for purposes of §6662(d)(2)(B) (without regard to §6662(d)(2)(C)) prior to the enactment of codification of economic substance it will be deemed to be adequate for purposes of §6662(i). The disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS consistent with the instructions and other guidance associated with those subsequent forms, publications, or other guidance.
Disclosures made consistent with the terms of Rev. Proc. 94-69 also will be taken into account for purposes of §6662(i). However, where a transaction lacking economic substance is a reportable transaction, as defined in Treas. Reg. § 1.6011-4(b), the adequate disclosure requirement under section 6662(i)(2) will be satisfied only if the taxpayer meets the disclosure requirements described earlier in this paragraph and the disclosure requirements under the §6011 regulations. In other words, a taxpayer will not meet the disclosure requirements for a reportable transaction under the §6011 regulations by only attaching Form 8275 or 8275-R to an original or qualified amended return.
Finally, Notice 2010-62 states that the Service will not issue a private letter ruling or determination letter regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o).
The Notice is effective as of the enactment of §7701(o), March 10, 2010.