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IRS Clarifies Terms Relating to the Economic Substance Doctrine.
(Parker Tax Publishing October 30, 2014)

The IRS has provided additional guidance on the codification of the economic substance doctrine and related penalty amendments. Notice 2014-58.

The economic substance doctrine is a judicially created rule, now codified under Code Sec. 7701(o), that disallows tax benefits if the transaction that produces those benefits lacks economic substance or a business purpose. Under Code Sec. 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 the transaction. Code Sec. 7701(o)(5)(D) provides that the term "transaction" includes a series of transactions. The legislative history of Code Sec. 7701 explained that it was not meant to alter a court's ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the economic substance doctrine. However, the code does not define "transaction."

Code Sec. 6662(b)(6) imposes a penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance or fails to meet the requirements of any similar rule of law. Neither Code Sec. 7701(o) nor Code Sec. 6662 defines "similar rule of law." However, the legislative history provides that, with respect to a "similar rule of law," 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 Code Sec. 7701(o) for an economic substance analysis, even if a different term is used to describe the doctrine.

In Notice 2014-58, the IRS provided a definition of "transaction" for purposes of the economic substance doctrine. The notice states that a 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." Furthermore, the IRS clarified that a facts and circumstances analysis will determine whether a plan's steps are aggregated or disaggregated when defining a transaction, focusing on whether particular steps are necessary to accomplish non-tax goals. The IRS elaborated that the economic substance doctrine's application and a transaction's character as an aggregation or disaggregation will be determined on a case-by-case basis in light of the facts and circumstances.

The IRS also advised that, for purposes of Code Sec. 6662(b)(6), "similar rule of law" means a rule or doctrine that disallows the tax benefits 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 Code Sec. 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.

The IRS said that it will not apply a penalty under Code Sec. 6662(b)(6) unless it also raises Code Sec. 7701(o) to support the underlying adjustments. If the IRS instead relies on other judicial doctrines (e.g., the step-transaction doctrine) to disallow claimed tax benefits and to support underlying adjustments, the IRS will not apply a Code Sec. 6662(b)(6) penalty.

Notice 2014-58 is effective for transactions entered into after March 30, 2010.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,730. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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