The IRS on Oct. 9 issued a notice providing additional guidance on the codification of the economic substance doctrine and related penalty amendments.
Notice 2014-58 amplifies Notice 2010-62, and provides guidance on the definition of “transaction” in applying the economic substance doctrine under Section 7701(o) and on the meaning of “similar rule of law” under the Section 6662(b)(6) accuracy-related penalty. It is effective for transactions entered into after March 30, 2010.
Congress codified the doctrine in 2010 by adding Section 7701(o), which states that a transaction has economic substance if it meets a two-part test: The transaction must change in a meaningful way, apart from federal income tax effects, a taxpayer’s economic position, and the taxpayer must have a substantial purpose, aside from federal income tax effects, for entering into the transaction.
The notice applies an aggregation definition to transaction, in that a transaction 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.” Thus, when a plan involves a series of interconnected steps with a common objective, the transaction is considered to include all of the steps in the aggregate — resulting in each step’s being considered when analyzing whether the transaction as a whole lacks economic substance.
When a plan includes a series of steps, including a tax-motivated step that isn’t necessary to achieve a nontax objective, the notice indicates that the IRS may apply a disaggregation approach to determine whether any of the individual tax-motivated steps is considered a transaction subject to the economic substance doctrine. So, the IRS is free to aggregate or disaggregate steps of an overall transaction in assessing the application of the economic substance doctrine.
Sections 6662(b)(6) and 6662(i) together impose a per se 40% penalty for transactions that fail the economic substance doctrine or a “similar rule of law.” The notice indicates that a similar rule of law is a rule or doctrine that applies the same factors or analysis as required under Section 7701(o), even if the doctrine is called something different. The notice gives the example of the “sham transaction doctrine.”
The potential expansion of the types of transactions that could give rise to a per se 40% penalty is troublesome and will likely add uncertainty. The notice indicates that no penalty would be applied under the economic substance doctrine or under a “similar rule of law,” however, unless the IRS successfully asserted that the transaction failed the economic substance doctrine under Section 7701(o). Thus, for example, if the IRS successfully asserted that a transaction shouldn’t be respected solely under step-transaction doctrine, the IRS couldn’t later decide to impose the 40% penalty on the theory that the step-transaction doctrine is a similar rule of law to the economic substance doctrine.