IRS Notice 2010-62 provides interim guidance regarding the codification of the economic substance doctrine under section 7701(o) of the Internal Revenue Code. The notice applies with respect to transactions entered into on or after March 31, 2010. For prior coverage of this issue, please see this prior alert.
For transactions entered into on or after March 31, 2010 to which the economic substance doctrine is relevant, section 7701(o)(1) mandates the use of a conjunctive two-prong test to determine whether a transaction has economic substance. The first prong requires that the transaction change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position. This prong generally is satisfied by a showing that the transaction is expected to produce an economic profit on a pre-tax basis. The second prong requires that the taxpayer to have a substantial non-tax business purpose for entering into the transaction.
The IRS will challenge transactions entered into on or after March 31, 2010 where the taxpayer takes the position that the transaction has economic substance merely because it satisfies either the economic profit test or the business purpose test. For all such transactions that otherwise would have been subject to a common-law economic substance analysis, the IRS will apply the two-prong conjunctive test consistent with section 7701(o).
Whether a transaction is subject to the economic substance doctrine — whether the doctrine is “relevant” to a transaction — will be determined in the same manner as if section 7701(o) had never been enacted. The IRS will continue to rely on relevant case law under the common-law economic substance doctrine in applying the two-prong conjunctive test in section 7701(o)(1). Accordingly, in determining whether a transaction sufficiently affects the taxpayer’s economic position, the IRS will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction does not satisfy the economic profit prong of the economic substance doctrine. Similarly, in determining whether a transaction has a sufficient non-tax business purpose, the IRS will apply cases under the common-law economic substance doctrine pertaining to whether the tax benefits of a transaction are not allowable because the transaction lacks a business purpose.
The IRS anticipates that the case law regarding the circumstances in which the economic substance doctrine is relevant will continue to develop. The codification of the economic substance doctrine should not affect the ongoing development of authorities on this issue.
In determining whether the requirements of section 7701(o) are met, the Service will take into account the taxpayer’s profit motive only if the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for Federal income tax purposes. In performing this calculation, the Service “will apply existing relevant case law and other published guidance.” This statement is interesting because the only decision that has actually adopted a present value approach to pre-tax profit is Wells Fargo & Company v. United States, No. 06-628T (Fed. Cl. Jan. 8, 2010). That decision is being appealed to the D.C. Circuit Court of Appeals. The issue may also be addressed in a similar docketed case also being tried in the Court of Federal Claims.
The IRS does not elaborate on, or even mention, the “angel list” of transactions that are identified in the Congressional legislative history of section 7701(o) as transactions to which the economic substance doctrine (and hence section 7701(o)) is not relevant. Included in this list are transactions with specifically mandated tax incentives such as Section 45 and 48 tax credits for renewable energy. The 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. The IRS will not issue a private letter ruling or determination letter regarding whether the economic substance doctrine is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o).
Members of the tax bar are disappointed with the IRS’ decision not to provide additional safe harbors in light of the new penalty regime that accompanies section 7701(o). The penalty for an underpayment attributable to the disallowance of a claimed tax benefit because a transaction lacks economic substance is a strict liability penalty – no reasonable cause exception applies. The penalty is 20% of the underpayment but is increased to 40% if the relevant facts affecting the tax treatment are not adequately disclosed on the taxpayer’s return.