• IRS Issues Field Directive on Economic Substance
  • July 21, 2011 | Authors: Armando Gomez; Julia M. Kazaks; Pamela F. Olson; Cary D. Pugh
  • Law Firm: Skadden, Arps, Slate, Meagher & Flom LLP - Washington Office
  • On July 15, 2011, the Internal Revenue Service (the Service) released a directive providing guidance for Service examiners and managers on the application of the codified economic substance doctrine and related penalties (the Directive).1 Although issued in the form of internal field instructions and not regulations or authoritative guidance, the Directive provides important information that will assist taxpayers in evaluating the potential application of the codified economic substance doctrine to proposed transactions and in dealing with examinations where the Service considers applying the doctrine to completed transactions.

    The Health Care and Education Affordability Reconciliation Act of 2010 (2010 Act) included amendments to the Internal Revenue Code of 1986 (the Code) codifying the economic substance doctrine and establishing a new strict liability penalty for transactions found to lack economic substance.2 On September 14, 2010, the Service issued a directive relating to the codification of the economic substance doctrine, which stated that to ensure consistent administration of the strict liability penalty, any proposal to impose the penalty at the examination level must be reviewed and approved by the appropriate Director Field Operations (DFO).3 Although that early signal that the Service would not pursue application of the strict liability penalty without prior approval from a DFO was welcome news in light of the stakes presented by the strict liability penalty, a number of professional organizations had sought a more detailed description of how the Service would evaluate whether to apply the penalty in the examination context and how taxpayers would be apprised that the issue was being considered. The Directive does just that.

    Limitations on Scope of the Strict Liability Penalty

    The most important part of the Directive is its instruction that the strict liability penalty will only be asserted in cases involving the economic substance doctrine. By providing that, until further guidance is issued, the strict liability penalty will not be asserted in situations involving a “similar rule of law,” the Directive provides an important limitation on the scope of the penalty. In particular, the Directive specifically mentions that the Service will not pursue the strict liability penalty when applying the step transaction, substance-over-form or sham doctrines.

    The Directive also appears to limit the ability of examiners to bifurcate transactions, stating that when a transaction involves a series of interconnected steps with a common objective, the term “transaction” generally refers to all of the steps taken together. If the examiner wants to bifurcate the transaction by applying the economic substance doctrine separately to one or more of the steps of the overall transaction, the examiner is required to first obtain guidance from their manager and local counsel.

    Factors to Be Considered in Evaluating Application of the Penalty

    The Directive identifies a number of facts and circumstances for examiners and manager to consider in assessing whether application of the economic substance doctrine is appropriate, including whether:

    • the transaction was promoted, developed or administered by the tax department or outside advisors;

    • the transaction is highly structured or involves unnecessary steps;

    • the transaction creates a meaningful economic change on a present value basis (pre-tax);

    • the taxpayer’s potential for gain or loss is not artificially limited;

    • the transaction accelerates a loss or duplicates a deduction;

    • the transaction generates a deduction that is matched by an equivalent economic loss or expense;

    • tax benefit is not artificially generated by the transaction; and

    • the transaction is not outside the taxpayer’s ordinary business operations.

    Taking a cue from the technical explanation drafted by the staff of the Joint Committee on Taxation contemporaneously with the congressional consideration of the 2010 Act, the Directive confirms that the application of the doctrine likely is not appropriate if the transaction being considered involves the following circumstances:

    • the transaction generates targeted tax incentives, in form and substance, consistent with the congressional intent in providing the incentives;

    • the transaction involves the choice between capitalizing a business enterprise with debt or equity;

    • the transaction involves a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment;

    • the transaction involves the choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; or

    • the transaction involves the choice to utilize a related-party entity in a transaction, provided that the arm’s-length standard of section 482 and other applicable concepts are satisfied.

    The factors listed in the Directive provide insight into one of the central questions raised by the codification of the economic substance doctrine, which is when the doctrine is “relevant.” The codified doctrine and the new strict liability penalty apply only when the economic substance doctrine is “relevant,” but provide no guidance regarding how to make that relevance determination. Although the Directive does not frame its guidance in terms of relevance, the factors listed set forth the Service’s preliminary views on when the doctrine applies. Taxpayers should carefully evaluate the presence or absence of the factors identified in the Directive when planning transactions.

    Guidance for Developing Cases Where the Penalty Might Apply

    The Directive requires examiners to consider a series of inquiries before seeking DFO approval to apply the economic substance doctrine. For example, the Directive instructs that application of the doctrine should not be pursued without higher level approval if the transaction involves tax credits, such as the low income housing credit or alternative energy credits, that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits. This is an important direction for the Service to provide, particularly when viewed in light of the focus of section 7701(o) on pre-tax profit potential.

    The Directive also suggests that examiners should not seek DFO approval to apply the economic substance doctrine when:

    • another judicial doctrine, such as the substance over form or step transaction doctrines, more appropriately addresses the transaction being examined;

    • if recharacterization (for example, debt as equity) more appropriately address the transaction being examined; or

    • if in considering all of the arguments available to challenge a claimed tax result, application of the economic substance doctrine is not among the strongest arguments available.

    These instructions confirm that the economic substance doctrine — and the accompanying strict liability penalty — is to be applied as a last resort. It also provides flexibility for examiners to utilize a variety of common-law theories to address audit issues without having to raise the prospect of the strict liability penalty.

    Procedural Considerations

    The Directive instructs examiners to notify a taxpayer that the examiner is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins to analyze the facts and circumstances described above. This is an important development in that it should permit taxpayers to engage with the examiner at an early stage to explain why it would not be appropriate to apply the economic substance doctrine to the transaction at issue.

    The Directive also instructs that before a decision is made by a DFO to approve a request to apply the economic substance doctrine, the DFO should provide the taxpayer with an opportunity to explain its position. While the Directive does not guarantee an in-person conference, by opening up the possibility of such meetings, it provides welcome assurance that the strict liability penalty will not be asserted without considered review by a Service executive.


    1 Internal Revenue Service, LB&I Directive for Industry Directors, et al. regarding Guidance for Examiners on the Codified Economic Substance Doctrine and Related Penalties (LB&I-4-0711-015) July 15, 2011.

    2 For a brief summary of the economic substance legislation, see Economic Substance Codified, March 30, 2010, available at http://www.skadden.com/content/Publications/Publications2022&under;0.pdf.

    3 Internal Revenue Service, LMSB Directive for Industry Directors, et al. regarding Codification of Economic Substance Doctrine and Related Penalties (LMSB-20-0910-024) Sept 14, 2010.