IRS Offers More Guidance on Economic Substance Doctrine
On October 10, 2014, the IRS issued Notice 2014-58 providing additional guidance concerning the economic substance doctrine and related penalties. The guidance defines “transaction” for purposes of applying the economic substance doctrine and “similar rule of law” for purposes of the accuracy-related penalty of section 6662(b)(6). The Notice states that is an “amplification” of an earlier notice, Notice 2010-62, and is retroactive to March 31, 2010.
Codification of the Economic Substance Doctrine
In 2010 Congress passed the Health Care and Education Affordability Reconciliation Act of 2010 which added a new paragraph (o) to section 7701 of the Internal Revenue Code clarifying and codifying the judicial economic substance doctrine. That doctrine had developed in the courts over a number of years, but was there was variation among the circuit courts in some critical aspects of the doctrine and the doctrine lacked a statutory foundation.
Section 7701(o)) states that, in the case of a transaction to which the economic substance doctrine is “relevant,” such transaction is treated as having economic substance only if a two-part test is met:
- The transaction changes in a meaningful way (apart from U.S. federal income tax effects) the taxpayer’s economic position; and
- The taxpayer has a substantial purpose (apart from U.S. federal income tax effects) for entering into the transaction.
Section 7701(o) states that the determination of whether the economic substance doctrine is relevant to a transaction must be made in the same manner as if section 7701(o) had never been enacted.
Earlier IRS Guidance
In September 2010, the IRS released interim guidance, Notice 2010-62, addressing the codified economic substance doctrine provision and related penalties. Notice 2010-62 applies to transactions entered into on or after March 31, 2010.
Notice 2010-62 provides little guidance as to when the IRS believes the economic substance doctrine is relevant. In the Notice, the IRS states that it will continue to analyze whether the economic substance doctrine applies in the same way that it did prior to the enactment of section 7701(o). The IRS states in the Notice that, if authorities determined the economic substance doctrine was not relevant to whether certain tax benefits are allowable prior to the enactment of section 7701(o), 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 further states that it anticipates case law regarding the circumstances in which the economic substance doctrine is relevant will continue to develop.
The IRS also states that Treasury 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. It also provides little guidance addressing how the IRS will apply the doctrine’s two-part test (economic substance and business purpose). In the Notice the IRS states that it will continue to rely on relevant case law defining the common-law economic substance doctrine for purposes of applying this conjunctive test.
Activity in the courts
The IRS continues to invoke the economic substance doctrine in challenging certain transactions it views as reaching an incorrect tax result even though arguable in technical compliance with the relevant provision of the tax law. For example, the IRS currently is seeking to deny U.S. taxpayers the benefit of a foreign tax credit in transactions structured as a loan by a non-U.S. lender to a U.S. borrower. These transactions, which were entered into before the enactment of section 7701(o), are structured so as to create foreign income taxes that are claimed as a credit by both the U.S. borrower and the non-U.S. lender (or a related party). A key issue in these cases is the how to define the “transaction” to which the economic substance doctrine should be applied. The IRS has sought to separate the transaction that creates the foreign tax liability from the larger transaction of which it is a part and argue that the isolated transaction failed to satisfy the economic substance doctrine.
Contents of Notice 2014-58
Section 7701(o)(5)(D) defines “transaction” to include a series of transactions. This definition suggest that Congress thought the economic substance doctrine should be applied to a transaction in a broad sense. Notice 2014-58 states that “whether economic substance doctrine is relevant and whether a transaction should be disaggregated will be considered on a case-by-case basis, depending upon the facts and circumstances of each individual case.” The notice also refers to the legislative history of section 7701(o): “[Section 7701(o)] does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine.” Thus, the Notice musters the legislative history to support the position on disaggregation that it is taking in some cases.
The notice also sheds light on the meaning of “similar rule of law” as used in section 6662(b)(6). That section provides a penalty when the taxpayer’s underpayment of tax stems from a transaction that fails to satisfy the economic substance doctrine or “a similar rule of law.” The notice states that “similar rule of law” means “a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) to support the underlying adjustments.” The notice refers to the substance-over-form and the step-transaction doctrines as being distinct from the economic substance doctrine. Thus, the IRS will not assert the section 6662(b)(6) penalty in cases where it argues that a transaction should be characterized under one of those doctrines.
The notice states that it is an amplification of Notice 2010-62 and that it is effective for transactions entered into after March 30, 2010.
Notice 2014-58 appears to represent somewhat of a shift in strategy by the IRS concerning the development of the economic substance doctrine. The IRS did not seek to define the scope of the economic substance doctrine in Notice 2010-62. It was satisfied to follow prior judicial decisions defining the doctrine and to allow the doctrine to continue to develop in the courts on a case-by-case basis as the IRS challenged particular transactions.
One reading of Notice 2014-58 is that the IRS now believes it is not bound by the definition of “transaction” as it develops in the case law. The IRS’s position may be that when Congress codified the economic substance doctrine in 2010 it implicitly provided the IRS with authority to issue interpretive regulations under section 7805 to define terms such as “transaction.” That would not be an unreasonable position for the IRS to take as there appears to be nothing in the sparse legislative history of section 7701(o) to limit he regulatory authority of the Executive branch. Whether the IRS can go beyond that, e.g., to identify transactions that per se lack economic substance is debatable.
Notice 2014-58, however, is simply a notice, and not a notice of proposed rulemaking, which typically would include a period for comment by interested persons and result in a Treasury regulation having the force of law. Thus, Notice 2014-58 probably is no more than a statement of the position that the government will take when raising the economic substance doctrine in litigation, and an indication of how the government will seek to influence development of the doctrine in the courts. If the IRS ultimately is not successful in developing the economic substance doctrine to its satisfaction through the courts, it may try to achieve the desired result by regulation. For now, however, that does not appear to be the case.
 See, e.g., Bank of New York Mellon v. Commissioner, 140 T.C. No. 15 (2013).KEYWORD: Economic Substance Doctrine
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