IRS LB&I Division Issues Guidance to Examiners on the Codified Economic Substance Doctrine

In March 2010, Congress codified the judicial economic substance doctrine in an effort to raise revenue as part of the health care reform legislation. The law provides for strict liability penalties of 20 percent for understated taxes and refund claims that result from transactions that lack economic substance. The strict liability understatement penalty increases to 40 percent for positions the taxpayer does not properly disclose on its tax returns. The Staff of the Joint Committee on Taxation estimated that the effect of codifying the doctrine and imposing the associated penalties will generate approximately $5 billion in tax revenues over the 10 years from 2010 to 2019. This relatively small amount of tax revenue may seem insignificant in the light of health care reform and the overall federal budget over a 10-year period. However, it is difficult to understate the concern that the strict liability penalty aspect of the economic substance legislation has caused among corporate taxpayers, tax planners and advisors. The judicial economic substance doctrine historically created great uncertainty for taxpayers, and for agents charged with enforcement, because it was difficult to predict how the courts would apply it to particular transactions.

Unfortunately, the language of the new code provision does not do much to provide comfort or guidance to taxpayers or agents as to its scope. The code section expressly incorporates by reference from the courts the common law definition of the doctrine of economic substance to the extent the case law is not inconsistent with the new code provision. In addition, the section provides that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”6 Despite numerous requests for Internal Revenue Service (IRS) written guidance, the IRS Chief Counsel’s Office has consistently stated that additional public guidance on when the doctrine is relevant and applicable would not be forthcoming. For example, in Notice 2010-62, released on Sept. 13, 2010, IRS Chief Counsel provided limited guidance on the disclosure requirements and the application of penalties and sought comments regarding the disclosure requirements, but nevertheless stated that “[t]he Treasury Department 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.”

This void in guidance regarding the application of the codified economic substance doctrine has been filled, in a more indirect manner, in the form of instructions to IRS auditors. In July 2011, the commissioner of the Large Business and International Division (LB&I) of the IRS evidently recognized this state of uncertainty and issued very helpful guidance to all LB&I examiners. The LB&I Directive provides examiners with a four-step framework for applying the doctrine and requires them to seek guidance from local managers and counsel and obtain approval from a Director of Field Operations (DFO; a high-level IRS manager) in all cases before applying the doctrine.

Before considering the substance of the LB&I Directive, it is useful to review the codification provision to understand the uncertainty inherent in the application of the judicial doctrine. In summary, the codified economic substance doctrine provides that a transaction will not be treated as having economic substance for tax purposes unless (1) it changes the taxpayer’s economic position “in a meaningful way” apart from federal income tax consequences, and (2) the taxpayer had a “substantial purpose” for entering the transaction apart from federal income tax consequences. If a taxpayer relies on the profit potential to pass this conjunctive test, the new section clarifies that the present value of the “reasonably expected pre-tax profit” potential must be “substantial” in relation to the expected tax benefits. Given the fact that the doctrine incorporates by reference a large, amorphous body of common law cases and turns on such words as “meaningful,” “substantial” and “reasonably expected,” it is easy to see how inconsistently it could be administered from agent to agent and taxpayer to taxpayer.