The economic substance doctrine is a longstanding judicial doctrine in tax law under which certain tax benefits with respect to a transaction are disallowed if the transaction does not have economic substance or lacks a business purpose. In 2010, the Internal Revenue Service codified the economic substance doctrine in section 7701(o) of the Internal Revenue Code. Under the codified doctrine, a transaction shall be treated as having economic substance only if both the objective and subjective prongs of a two-part conjunctive test are satisfied. In particular, the test requires that (1) the transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer must have a substantial non-income tax purpose for entering into the transaction.

Along with the enactment of section 7701(o), the IRS added section 6662(b)(6) to the Internal Revenue Code, which imposes a strict liability penalty of up to 40 percent of any underpayment of tax 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. With adequate disclosure of the transaction to the IRS, the penalty can be capped at 20 percent rather than 40 percent. The codified economic substance doctrine under section 7701(o) and the related strict liability accuracy-related penalty under section 6226(b)(6) apply to transactions entered into on or after March 30, 2010.

Notice 2014-58

On October 9, 2014, the IRS released a copy of Notice 2014-58 as additional guidance concerning the codified economic substance doctrine and the related section 6226(b)(6) penalty.1 The notice focuses on two issues: (1) the definition of “transaction” for purposes of applying the codified economic substance doctrine and (2) the meaning of “similar rule of law” as described in the accuracy-related penalty under section 6662(b)(6).

Meaning of Transaction

The Notice observes that section 7701(o)(5)(D) simply states that the term “transaction” includes a series of transactions. In clarifying the meaning of the term, Notice 2014-58 looked to the definition of “transaction” in the context of reportable transactions (i.e., transactions of a type that the IRS has determined as having a potential for tax avoidance or evasion). It also looked to the legislative history behind section 7701. Based on those two sources, the Notice specifically states that for purposes of determining whether the codified economic substance doctrine applies, the term “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement as well as any or all of the steps that are carried out as part of a plan. It further explains that when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction” generally should be considered as including all of the steps taken together. In other words, every step in the series will be considered when analyzing whether the “transaction” as a whole lacks economic substance. In some circumstances, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals. The individual facts and circumstances of each case determine whether the economic substance doctrine is relevant and whether a plan’s steps should be aggregated or disaggregated when defining a transaction.

Similar Rule of Law

The Notice observes that neither section 7701(o) nor section 6662 defines “similar rule of law.” To address the lack of a definition, Notice 2014-58 declares that “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under the two-part conjunctive test of section 7701(o) , even if a different term or terms (e.g., “sham transaction doctrine”) are used to describe the rule or doctrine. Thus, if the IRS does not raise the economic substance doctrine under section 7701(o) to disallow the claimed tax benefits and, instead, relies on other judicial doctrines such as the “substance over form doctrine” or the “step transaction doctrine”, the IRS will not apply a section 6662(b)(6) penalty because the IRS will treat the transaction as failing to meet the “similar rule of law” requirement. The notice also reiterates that the penalty under section 6662(b)(6) is a strict liability penalty. The reasonable cause defenses and reasonable basis defenses to penalties do not apply to the penalty under section 6226(b)(6).