IRS And Treasury Release New Economic Substance Doctrine Notice

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On October 9, 2014, the IRS and Treasury issued Notice 2014-58, 2014-44 IRB 1.  The notice is apparently the expected guidance that was part of the IRS and Treasury’s most recent priority guidance plan. The text of the notice is in the appendix below.

I. Background

The notice follows up on an initial notice issued in 2010 ([do action=”link-icon”/]Notice 2010-62, 2010-40 IRB 411) and two directives issued by LB&I thereafter (LMSB-20-0910-024, September 14, 2010, requiring the approval of the appropriate Director of Field Operations to assert the codified doctrine, and LB&I-4-0711-015, July 15, 2011, laying out the factors to be applied in assessing whether to impose the codified doctrine and restricting the penalty solely to violations of the codified doctrine). There have also been two Chief Counsel notices for coordination of economic substance doctrine cases. (See CC-2014-005, May 20, 2014, providing updated counsel coordination requirements, and CC-2013-008, April 3, 2012, providing the initial coordination with counsel requirements). I have written about these Chief Counsel notices [do action=”link-icon”/]here before.

The prior guidance was thin on practical guidance to implement section 7701(o). The initial notice basically said to rely on current case law and and also basically told us that there would be no comprehensive follow-up guidance. The two LB&I directives basically gave agents some general parameters on deciding whether to assert the doctrine but contained no substantive guidance.

II. Notice 2014-58

Notice 2014-58 provides additional guidance in two areas: (1) the definition of the term “transaction” in applying the codified doctrine, and (2) the meaning of “similar rule of law” in applying the penalty for violation of the codified doctrine .

1. Definition of “transaction”

A. The Notice states: “For purposes of determining whether the codified economic substance doctrine applies, “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.”

B. “Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction” includes all of the steps taken together – an aggregation approach. This means that every step in the series will be considered when analyzing whether the “transaction” as a whole lacks economic substance. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals – a disaggregation approach.”

C. “Whether the economic substance doctrine is relevant and whether a transaction should be disaggregated will be considered on a case-by-case basis, depending on the facts and circumstances of each individual case. For example, if transfers of multiple assets and liabilities occur and the transfer of a specific asset or assumption of a specific liability was tax-motivated and unnecessary to accomplish a non-tax objective, then the economic substance doctrine may be applied solely to the transfer or assumption of that specific asset or liability. Separable activities may take many forms including, for example, the use of an intermediary employed for tax benefits and whose actions or involvement was unnecessary to accomplish an overarching non-tax objective. These situations are merely examples intended to illustrate the potential application of the disaggregation approach and are not exhaustive or comprehensive.”

2. Similar Rule Of Law

A. “For purposes of section 6662(b)(6), “similar rule of law” means a rule or doctrine that disallows the tax benefits under subtitle A of the Code related to a transaction because: (1) the transaction does not change a taxpayer’s economic position in a meaningful way (apart from Federal income tax effects); or (2) the taxpayer did not have a substantial purpose (apart from Federal income tax effects) for entering into the transaction….In other words, “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis, even if a different term or terms (for example, “sham transaction doctrine”) are used to describe the rule or doctrine. See H.R. Rep. 111-443, at 304.”

B. “The IRS will not apply a penalty under section 6662(b)(6) (or otherwise argue that a transaction is described in section 6662(b)(6)) unless it also raises section 7701(o) to support the underlying adjustments. If the IRS does not raise section 7701(o) to disallow the claimed tax benefits and instead relies upon other judicial doctrines (e.g., the substance over form or step transaction doctrines) to support the underlying adjustments, the IRS will not apply a section 6662(b)(6) penalty (or otherwise argue that a transaction is described in section 6662(b)(6)) because the IRS will not treat the transaction as failing to meet the requirements of a similar rule of law. Code sections and Treasury regulations, other than section 7701(o) and the regulations under that section, that disallow tax benefits are not similar rules of law for purposes of section 6662(b)(6).”

3. Supplements Notice 2010-62 With Retroactive Effective Date

A. “EFFECT ON OTHER DOCUMENTS…Notice 2010-62, 2010-40 I.R.B. 411, is amplified.”

B. “EFFECTIVE DATE…This notice is effective for transactions entered into after March 30, 2010.”

III. Some Thoughts And Observations

1. The term “transaction” is generally defined by applying traditional step transaction principles; that is, by applying all interconnected steps of the transaction.

2. The notice says that the term “transaction” may, depending on the facts and circumstances, be defined by excluding specified assets or liabilities that are formally part of a larger set of transferred assets and liabilities but are not necessary to achieve the stated non-tax objectives, or by excluding intermediaries that are unnecessary to achieve the stated non-tax goals of the transaction. This is called “disaggregation”. The first example of this involving cherrypicking the assets and liabilities to be examined under the codified doctrine seems to be a repudiation of the Shell case (2008 WL 2714252 (SD Tex. 2008), where both productive and unproductive assets were transferred. The second example, the ignoring of the intermediary, seems to be an adoption of the Coltec approach where the subsidiary used to transfer the obligation did not appear to satisfy the stated business purpose of asset management and did not appear to insulate its owners from exposure on the transferred liability.

3. Caution is warranted here with respect to disregarding an intermediary as that could arguably be used to circumvent the principle of the step transaction doctrine that steps will not be created that did not actually occur and that steps are disregarded only if “unnecessary”. Caution is also warranted in disregarding selected assets or liabilities. This is because what steps are necessary to achieve the non-tax objectives may not be clear and in fact may be very debatable and a close factual call.

4. The provisions relating to “similar rule of law” should be very helpful. The notice requires that the codified economic substance doctrine be raised or the new penalty will not apply even if the IRS otherwise raises a similar rule of law (such as sham) or other common law principles or doctrines. The notice also states that other Code or regulatory rules that disallow tax benefits other than section 7701(o) are not similar rules of law. This would appear to exclude section 482, section 269 or regulation section 1.701-2.

5. Overally, the notice appears to be a step in the right direction but clearly more guidance is urgently needed under the codified ESD statute.

APPENDIX

Additional Guidance Under the Codified Economic Substance Doctrine and Related

Penalties

Notice 2014-58

PURPOSE

This notice amplifies Notice 2010-62, 2010-40 I.R.B. 411, by providing additional guidance regarding the codification of the economic substance doctrine and the related penalty amendments. Specifically, this notice provides guidance regarding: (1) the definition of “transaction” for purposes of applying the codified economic substance doctrine under section 7701(o), and (2) the meaning of “similar rule of law” as described in the accuracy-related penalty under section 6662(b)(6). This notice is also relevant with respect to the availability of the reasonable cause exceptions under sections 6664(c) and (d) and the reasonable basis exception under section 6676 because those exceptions are inapplicable to transactions described in section 6662(b)(6).

BACKGROUND

The economic substance doctrine is a judicial doctrine that was codified in section 7701(o) by section 1409 of the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152. Section 7701(o)(5)(A) defines “economic substance doctrine” as the common-law doctrine that disallows tax benefits under subtitle A of the Internal Revenue Code if the transaction that produces those benefits lacks economic substance or a business purpose. Under section 7701(o)(1), a transaction has economic substance if: (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.

Section 7701(o)(5)(D) provides that “[t]he term ‘transaction’ includes a series of transactions.” The legislative history explained: The provision does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine. For example, the provision reiterates the present-law ability of the courts to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits. H.R. Rep. No. 111-443(I), at 296-297, P.L. 111-152, Health Care and Education Reconciliation Act of 2010. Although section 7701(o) does not provide a definition of “transaction,” the term has been defined in the analogous context of reportable transactions. Specifically, Treas. Reg. § 1.6011-4(b)(1) provides that, for purposes of the reportable transaction disclosure regime, the term “transaction” includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement and also includes any series of steps carried out as part of a plan.

Section 6662(b)(6) imposes a penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance (within the meaning of section 7701(o)) or fails to meet the requirements of any similar rule of law. Neither section 7701(o) nor section 6662 defines “similar rule of law.” However, the legislative history explained, with respect to a “similar rule of law,” that the “penalty would apply to a transaction that is disregarded as a result of the application of the same factors and analysis that is required under the provision [section 7701(o)] for an economic substance analysis, even if a different term is used to describe the doctrine.” H.R. Rep. 111-443(I), at 304.

Sections 6664(c)(2) and (d)(2) provide that the reasonable cause and good faith exception to a section 6662 or 6662A penalty does not apply to the portion of an underpayment or reportable transaction understatement attributable to one or more transactions described in section 6662(b)(6). For purposes of the penalty for an erroneous claim for refund or credit of an excessive amount, section 6676(c) provides that any excessive amount (within the meaning of section 6676(b)) that is attributable to any transaction described in section 6662(b)(6) is not treated as having a reasonable basis.

DISCUSSION

A. Transaction

For purposes of determining whether the codified economic substance doctrine applies, “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.

Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction” includes all of the steps taken together – an aggregation approach. This means that every step in the series will be considered when analyzing whether the “transaction” as a whole lacks economic substance. However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals – a disaggregation approach.

Whether the economic substance doctrine is relevant and whether a transaction should be disaggregated will be considered on a case-by-case basis, depending on the facts and circumstances of each individual case. For example, if transfers of multiple assets and liabilities occur and the transfer of a specific asset or assumption of a specific liability was tax-motivated and unnecessary to accomplish a non-tax objective, then the economic substance doctrine may be applied solely to the transfer or assumption of that specific asset or liability. Separable activities may take many forms including, for example, the use of an intermediary employed for tax benefits and whose actions or involvement was unnecessary to accomplish an overarching non-tax objective. These situations are merely examples intended to illustrate the potential application of the disaggregation approach and are not exhaustive or comprehensive.

B. Similar Rule of Law

For purposes of section 6662(b)(6), “similar rule of law” means a rule or doctrine that disallows the tax benefits under subtitle A of the Code related to a transaction because: (1) the transaction does not change a taxpayer’s economic position in a meaningful way (apart from Federal income tax effects); or (2) the taxpayer did not have a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

In other words, “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis, even if a different term or terms (for example, “sham transaction doctrine”) are used to describe the rule or doctrine. See H.R. Rep. 111-443, at 304.

The IRS will not apply a penalty under section 6662(b)(6) (or otherwise argue that a transaction is described in section 6662(b)(6)) unless it also raises section 7701(o) to support the underlying adjustments. If the IRS does not raise section 7701(o) to disallow the claimed tax benefits and instead relies upon other judicial doctrines (e.g., the substance over form or step transaction doctrines) to support the underlying adjustments, the IRS will not apply a section 6662(b)(6) penalty (or otherwise argue that a transaction is described in section 6662(b)(6)) because the IRS will not treat the transaction as failing to meet the requirements of a similar rule of law. Code sections and Treasury regulations, other than section 7701(o) and the regulations under that section, that disallow tax benefits are not similar rules of law for purposes of section 6662(b)(6).

EFFECT ON OTHER DOCUMENTS

Notice 2010-62, 2010-40 I.R.B. 411, is amplified.

EFFECTIVE DATE

This notice is effective for transactions entered into after March 30, 2010.

CONTACT INFORMATION

The principal author of this notice is James G. Hartford of the Office of Associate Chief Counsel (Procedure and Administration). For further information regarding this notice, contact Mr. Hartford at (202) 317-3400 (not a toll-free call).

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