On July 15, 2011, the Internal Revenue Service issued guidance1 to its examining agents addressing when and how to assert the "no fault" penalty2 for failure of a transaction to meet the recently codified economic substance doctrine. While the directive is addressed solely to IRS examining agents, the guidance should prove useful to both taxpayers and their representatives in determining (a) how the IRS seeks to apply the standard of economic substance, and (b) the procedures followed and opportunities to defend against possible assertion by the IRS that a transaction or series of transactions lacks economic substance. If applied, the penalty (the "no-economic-substance penalty") is levied at 20% (or 40% absent adequate disclosure) of the underpayment attributable to the failure to meet the economic substance hurdle.
The economic substance doctrine developed over time through
court cases, and as such, the legal standard could be said to have
varied depending upon which court a taxpayer found itself in.
Congress seized the opportunity in 2010 to clarify that a harsher
approach should apply, which requires meeting a two part test.
Section 7701(o)3 now provides 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." After much lobbying by the legal and accounting
professions, Congress included a provision limiting when the IRS
could assert that economic substance is relevant, specifying in the
statute that "the determination of whether the economic
substance doctrine is relevant to a transaction shall be made in
the same manner as if [the economic substance doctrine had not been
Recognizing the strict liability nature of the no-economic-substance penalty and, thus, the importance of applying the penalty uniformly and fairly, the IRS issued a directive in September 2010 that required any examining agent who sought to apply the penalty to obtain approval from the appropriate Director of Field Operations. That directive did not provide guidance to examining agents about when or how they could seek to apply the penalty. The new directive partially fills that gap.
Operation of the New Directive
The directive requires that if an agent thinks he or she might
want to assert a penalty for failure of a transaction or series of
transactions to meet the economic substance standard, four steps
must be followed. This process should prevent relatively automatic
assertions of the new penalty. Taxpayers are to be notified as the
examining agent undertakes his or her analysis and presumably
taxpayers and their advisers can weigh in at that stage. It is
important to recognize, however, that while the recent directive
provides a roadmap to taxpayers seeking to block assertion of the
economic substance penalty, the examining agent retains the power
to assert it, subject to convincing others at the IRS that
imposition of the penalty is warranted.
Step 1 requires the examining agent to consider whether the facts and circumstances indicate that the application of the economic substance doctrine is "likely not appropriate" to the transaction. The directive includes a list of 18 situations that may "tend to show" that the economic substance doctrine is likely not appropriate, but none of these cases would actually prevent the assertion of economic substance challenge. Among the situations that may tend to show that the no economic substance penalty should be asserted include transactions that are not "prepackaged" or promoted by the taxpayer's tax department or an outside advisor; transactions that are not "highly structured;" transactions that contain no "unnecessary steps;" and transactions that do not "artificially" limit the taxpayer's potential for gain or loss. Importantly, transactions that generate "targeted tax incentives in form and substance consistent with Congressional intent" are in the list-of-18.
The directive also identifies four circumstances in which a no-economic-substance penalty is likely not appropriate: debt-or-equity capitalization decisions; choosing a foreign blocker to conduct foreign investment; incorporation or reorganization of a corporation; and use of a related party in a transaction meeting the arm's length pricing standard of section 482.
Step 2 lists 17 circumstances that tend to show that the application of the economic substance doctrine may be appropriate, including acceleration or duplication of deductions; using tax-indifferent counterparties that recognize substantial income; separating income and related expense items over different taxable periods or different taxpayers; and transactions that have no credible business purpose (other than federal tax benefits), no meaningful potential for profit (other than tax benefits), or no significant risk of loss.
Step 3 requires an examining agent to answer a series of seven questions before seeking approval to assert the no-economic-substance penalty, including generally whether the transaction involves a statutory or regulatory election; whether the transaction is subject to a detailed statutory or regulatory scheme; whether precedent relating to the application of the economic substance doctrine's application to the type of transaction exists; whether the transaction involves tax credits; whether another judicial doctrine more appropriately addresses the alleged noncompliance; whether recharacterizing the transaction more appropriately addresses the alleged noncompliance; and whether, considering all arguments available to challenge the claimed tax result, the application of the economic substance doctrine is the strongest. In connection with answering these questions, the agent is directed to seek advice from the agent's IRS manager "in consultation with local [IRS] counsel."
Step 4 of the directive addresses how to obtain approval from the Director of Field Operations, including the requirement of a written report from the examining agent; the Director of Field operations will engage in a consultative process involving the examiner's manager, territorial manager, input from IRS counsel. If the Director determines that he or she considers the no-economic-substance penalty appropriate, the taxpayer will be permitted an opportunity to explain their position in person or in writing (at the Director's discretion).
This directive provides the most meaningful insight into the
process for assertion of the no-economic-substance penalty.
Taxpayers and their representatives would be well served to
consider the details of this directive if an agent begins to hint
that he or she may seek to investigate whether the penalty might
apply. There are numerous opportunities to defend against assertion
of the penalty or at least to become familiar with the opportunity
to convince the IRS not to travel all the way down that road.
The directive also provides taxpayers and their advisers further insight into the measure of economic substance the IRS may seek to adopt and, in that respect, the directive is of even wider interest.
1 LB&I-4-0711-015, impacting sections 20.1.1 and .5
of the Internal Revenue Manual.
2 The penalty is considered "no fault" because no "reasonable cause" exception will apply.
3 References in this Flash to "section" or "§" are to sections of the Internal Revenue Code of 1986, as amended, unless otherwise stated. Section 7701(o)(5)(C).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.