On July 15, 2011, the Internal Revenue Service Large Business & International (LB&I) Division released a directive (LB&I Control No: LB&I-4-0711-015) providing guidance to Examiners and Managers on when it is appropriate to seek the approval of the Director of Field Operations (DFO) to raise the codified economic substance doctrine.

Codified Economic Substance Doctrine

For transactions entered into after March 30, 2010, a transaction to which the economic substance doctrine is relevant is treated as having economic substance only if it meets the conjunctive two-prong test in Section 7701(o) of the Internal Revenue Code:

  1. the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
  2. the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

Related Penalties

Section 6662(b)(6) imposes a strict liability penalty of 20 percent (40 percent for undisclosed transactions per Section 6662(i)) of any underpayment attributable to the disallowance of claimed tax benefits by reason of the application of the economic substance doctrine. Section 6676 provides that a strict liability penalty of 20 percent also applies to refund claims that fail to meet the requirements of the economic substance doctrine.

These same statutes also provide for a penalty for a transaction that fails to meet the requirements of any “similar rule of law” (e.g. step transaction doctrine, substance over form, or sham transaction). However, the directive advises Examiners that, until further notice, these penalties are not to be imposed.

Four Steps of the LB&I Directive

If the Examiner believes that raising the economic substance doctrine is warranted, the directive provides a series of four steps that the Examiner must apply in order to seek approval for the application of the doctrine The examiner is instructed to notify the taxpayer before beginning the four steps.

  1. The Examiner must evaluate the facts and circumstances of the transaction to determine if they tend to show that the application of the doctrine is not appropriate. Some examples of factors that show the application of the doctrine is not appropriate are: (i) the transaction is not highly structured; (ii) the transaction contains no unnecessary steps; (iii) the taxpayer’s potential for gain is not artificially limited; (iv) the transaction has significant risk of loss; (v) the transaction is not pre-packaged; and (vi) the transaction is not outside the taxpayer’s ordinary business operations.
  2. The Examiner must next evaluate the facts and circumstances of the transaction to determine whether the application of the doctrine is appropriate. The factors used for this step are essentially identical to the factors listed in the first step, but of course a negative answer to the factors indicates that application of the doctrine may be appropriate.
  3. If after applying the first two steps the Examiner believes that the application of the doctrine is appropriate, he or she must address seven questions before seeking the approval of the DFO.

If the answer is “yes” to any of the following questions (i)-(iv), or “no” to question (vii), then the Examiner cannot pursue application of the doctrine without the approval of his or her Manager in consultation with local Counsel. Also, in answering questions (v) and (vi), the Examiner should seek the advice of his or her Manager in consultation with local Counsel.

  1. Is the transaction a statutory or regulatory election?
  2. Is the transaction subject to a detailed statutory or regulatory scheme and, if so, does the transaction comply with the scheme?
  3. Does precedent exist that either rejects the application of the doctrine to the type of transaction or upholds the transaction and makes no reference to the doctrine when considering the transaction?
  4. Does the transaction involve tax credits that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?
  5. Does another judicial doctrine more appropriately address the noncompliance that is being examined?
  6. Does recharacterizing a transaction more appropriately address the noncompliance that is being examined?
  7. In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available?  
  1. If after applying steps (1) through (3) the Examiner concludes that it is appropriate to seek approval for the application of the doctrine, the Examiner, in consultation with his or her Manager and Territory Manager, should describe in writing how the analysis was completed and provide this document to the appropriate DFO. The DFO will then review the written material and consult with Counsel. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain the position. The DFO should convey the final decision to the Examiner in writing.

It appears that with the codification of the doctrine and the related strict liability penalty, the purpose of the directive is to put in place some safeguards to prevent the misapplication of these provisions. Although the directive is only guidance to the Examiners, it may be a helpful tool for taxpayers to correct an Examiner who is not properly applying the doctrine.