By Mark D. Allison, Christopher S. Rizek and Charles M. Ruchelman
Waiting for Guidance
As most tax practitioners are aware, the Health Care and Education Reconciliation Act of 2010 added new section 7701(o) of the Internal Revenue Code (the "Code"). This provision codified the judicial doctrine of economic substance.1 Along
with the new codification provision, a new penalty was added under Code
section 6662(i) for non-disclosed, non-economic substance
transactions. The provision imposes a 40% penalty and does not allow the
usual reasonable-cause defense to penalties. Since enactment,
practitioners have raised concerns about how and when the Internal
Revenue Service ("IRS") will apply the new provisions.
The LB&I Directive and Its Four-Step Approval Process
On July 15th, the Large Business & International Division
("LB&I") issued guidance for examiners and managers on the codified
economic substance doctrine and related penalties. LB&I-4-0711-015
(July 15, 2011). The guidance provides a series of questions the
examiner must develop and analyze in order to seek approval for the
application of the economic substance doctrine to a transaction.
Previously, LB&I Directive LMSB-20-0910-024 (Sept. 14, 2010)
stated that any proposal to apply the economic substance doctrine at the
examination level must be reviewed and approved by the appropriate
Director of Field Operations ("DFO"). The newly released guidance
provides a four-step process that instructs examiners and their managers
on how to determine when it is "appropriate" to seek the approval of
the DFO in order to raise the economic substance doctrine. It fails,
however, to use the "relevant" language found in the statute. The
guidance also states that the penalties provided in Code sections
6662(b)(6) and (i) and 6676 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 (e.g., step transaction doctrine, substance over form or sham transaction).
The
first and second step require the examiner to determine whether the
circumstances in the case are those under which application of the
economic substance doctrine to a transaction is appropriate. The facts
and circumstances the examiner must analyze can be placed into three
categories-the design, mechanics, and substance of the transaction. The
"design" factors generally relate to things like who promoted or
developed the transaction, whether it is highly structured or contains
unnecessary steps, or whether tax-indifferent parties recognize
substantial income. The "mechanics" factors include whether the
transaction is at arm's length with unrelated third parties, accelerates
a loss or duplicates a deduction, or generates a deduction that is not
matched by an equivalent economic loss or expense. The "substance"
factors relate to whether the transaction is consistent with
Congressional intent in providing the incentives, creates a meaningful
economic change on a present value basis or has a potential for profit,
has a credible business purpose apart from tax benefits, or has
significant risk of loss.
If the examiner believes that the
facts and circumstances of a transaction show that application of the
economic substance doctrine is appropriate, the examiner must then
answer another set of questions before seeking the DFO's approval for
application of the doctrine. The questions ask whether application of
the economic substance doctrine is the best course of action (e.g.,
is it the best argument available, or does recharacterizing the
transaction or applying another judicial doctrine more appropriately
address the noncompliance), and whether the doctrine might otherwise
apply but is not appropriate for another reason (e.g., does the
transaction involve credits designed by Congress to encourage the
transaction, do courts reject application or fail to mention the
doctrine when analyzing similar transactions, or is the transaction a
statutory or regulatory election or subject to a detailed statutory or
regulatory scheme).
Angel List?
Tax
practitioners have been clamoring for an "angel list" - transactions
that are exempt from application of the economic substance doctrine. The
guidance does not clearly set forth such an angel list. It does,
however, make clear that the economic substance doctrine is likely not
appropriate when the transaction relates to the choice between
capitalizing a business with debt or equity; a U.S. person's choice
between using a domestic or foreign corporation in making a foreign
investment; the choice to enter into a transaction or series of
transactions that constitute a corporate organization or reorganization
under subchapter C; or the choice to utilize a related-party entity in a
transaction, provided that the arm's length standard of Code section
482 and other applicable concepts are satisfied. If the IRS believes
the doctrine should nevertheless be applied to a transaction, the DFO
will provide the taxpayer an opportunity to explain his/her position
regarding it.
The Take-Away
Caplin &
Drysdale believes that the new guidance is very helpful. The extensive
list of factors should be reviewed by tax advisors and
carefully considered in analyzing the possible application of the
economic substance doctrine to particular transactions. During a tax
examination, the factors should be reviewed with the revenue agent to
demonstrate why the new statute does not apply. The guidance also
demonstrates that the IRS has put in place a process under which the IRS
examiner, manager, and DFO must operate before application of the
penalty.
If you have additional questions about this alert, contact your Caplin & Drysdale representative or contact:
Mark D. Allison at 212.319.8710 or mallison@capdale.com
Christopher S. Rizek at 202.862.8852 or crizek@capdale.com
Charles M. Ruchelman at 202.862.7834 or cruchelman@capdale.com
FOOTNOTE:
- Section 7701(o) states that "[i]n the case of any transaction to
which the economic substance doctrine is relevant, such transaction
shall be treated as having economic substance only if - (A) the
transaction changes in a meaningful way (apart from Federal income tax
effects) the taxpayer's economic position, and (B) the taxpayer has a
substantial purpose (apart from Federal income tax effects) for entering
into such transaction." The statute further states that the
determination of whether the economic substance doctrine is relevant to a
transaction will be made in the same manner as if section 7701(o) had
never been enacted.
About the Caplin & Drysdale Tax Controversy and Litigation Team
Caplin
& Drysdale is a boutique tax law firm with over 40 lawyers with a
tax-focused practice. Our core Tax Controversy and Litigation team
consists of six members, one senior counsel, and six associates. Two of
our lawyers are located in New York City, and the other eleven lawyers
are located in Washington, D.C.
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