Notice Provides Little Meaningful Guidance on the IRS’s Plans to Administer the Economic Substance Doctrine Statute; LMSB Directive Requires High-Level Review Before Assertion of Strict Liability Penalty

Tax Alert

On September 13, 2010, the IRS issued Notice 2010-62 (the "Notice"), its initial guidance regarding the codification of the economic substance doctrine under Section 7701(o) as enacted by the Health Care and Education Reconciliation Act of 2010. The guidance is a disappointment as it largely restates the terms of the statute and provides little meaningful guidance on the IRS’s plans to administer the statute. The Notice provides no real indication of how the IRS will determine when the economic substance doctrine should be applied to a particular transaction, merely repeating the statutory mandate that the determination will be made consistent with the case law. Further, the Notice provides that the IRS will not issue a so-called "angel list" exempting some types of transactions to from the doctrine’s application. The Notice was followed by the issuance of a directive to IRS examiners from the Large and Mid-Size Business Division (the "LMSB Directive") on September 14, 2010 requiring high-level review by LMSB before assertion of the economic substance doctrine strict liability penalty. This alert discusses the practical implications of the IRS’s decision to provide so little meaningful guidance on the doctrine, as well as the practical implications of the review required by the LMSB Directive.

Overview of the Statute

Section 7701(o) adopts a conjunctive two-part economic substance standard by providing that:

[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if— (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

Thus, a transaction subject to the economic substance standard must lead to a non-tax change in economic position and the taxpayer must have a non-tax business purpose for entering the transaction. Underpayments attributable to a transaction that is determined to lack economic substance under this two-prong test are subject to a 20 percent strict liability penalty, which is increased to 40 percent if the taxpayer does not disclose the transaction in its return. See Practical Implications of the Codification of the Economic Substance Doctrine, April 5, 2010.

Determination of Relevancy

The statute provides circular guidance on the threshold issue of whether the economic substance standard should apply to a transaction. Section 7701(o) states that it will apply "[i]n the case of any transaction in which the economic substance doctrine is relevant." The statute later explains 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." Consistent with this statutory language, the Notice provides that "the IRS will continue to analyze when the economic substance doctrine will apply in the same fashion as it did prior to the enactment of section 7701(o)." The Notice expands on the IRS’s intent to rely on prior law, noting that "[i]f authorities, prior to the enactment of section 7701(o), provided that the economic substance doctrine was not relevant to whether certain tax benefits are allowable, the IRS will continue to take the position that the economic substance doctrine is not relevant to whether those tax benefits are allowable." Thus, where it appears that Congress intended tax benefits notwithstanding the lack of non-tax business purpose (for example, certain tax credits designed to provide an incentive for otherwise non-economic investment) the IRS apparently will not assert application of the economic substance doctrine. That said, the case law in this area does not provide a ready framework for determining whether the economic substance doctrine is "relevant" to a transaction -- courts historically have simply chosen to apply the doctrine in some case, but not others, without analyzing as a separate step whether the doctrine is relevant.

A major difficulty with the statute is that it raises the stakes for a violation of the economic substance by a strict liability penalty for understatements due to economic substance violations. Accordingly, the determination of whether the economic substance doctrine is relevant to a transaction impacts not only the tax associated with the transaction, but also whether the strict liability penalty applies. The statute provides, however, that taxpayers may avoid the penalty through adequate disclosure of a transaction. Therefore, as discussed below, the ambiguity surrounding the "relevance" issue, when combined with the strict liability penalty, may cause taxpayers to "over-disclose" transactions under section 7701(o) by filing disclosures for garden-variety tax planning. Such tendency to "over-disclose" may be tempered, however, by the high-level review required pursuant to the LMSB Directive prior to the assertion of the strict liability penalty.

Rejection of an "Angel List" Approach

The Joint Committee on Taxation’s explanation accompanying the statute (the "JCT Explanation") provides some general guidance concerning the inapplicability of Section 7701(o) to garden-variety tax planning. The JCT Explanation notes that the statute is "not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages." The JCT Explanation provides illustrative examples of such basic transactions, including (i) form of capitalization of a business enterprise (i.e., debt or equity), (ii) utilization of a domestic or foreign corporation to make a foreign investment, and (iii) corporate organizations or reorganizations.

Numerous commentators suggested that the IRS formalize and expand the illustrative examples contained in the JCT Explanation into a so-called "angel list" of transactions that are exempted from the application of the economic substance doctrine. In public statements, however, Treasury and IRS officials consistently rejected the notion of an "angel list" for a variety of reasons, including concerns that such a list would undoubtedly be either over-inclusive or under-inclusive. Consistent with these statements, the Notice rejects the "angel list" approach noting "[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." Indeed, the Notice makes no reference whatsoever to the JCT Explanation on this point.

Practical Implications

Without an "angel list," taxpayers may be left to wonder whether garden-variety tax planning, such as a check-the-box election, could potentially be subject to later challenge by the IRS under the economic substance doctrine. This uncertainty is exacerbated by the fact that the Notice explicitly states that the IRS will not issue a ruling letter or a 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). Nevertheless, while the IRS may refuse to address whether the doctrine is relevant to a transaction, a ruling on the tax consequences of a transaction may carry with it an implicit determination that the transaction does not run afoul of any judicial doctrines. As a practical matter, the time and expense associated with such rulings may limit the number of these types of requests. Given this uncertainty, taxpayers may have an incentive to "over-disclose" transactions on their returns to protect against a possible 40 percent strict liability penalty (particularly given that the IRS has indicated that disclosure of transactions with a FIN 48 reserve is expected to be required beginning with the 2010 tax year).

Additional Commentary on Scope Anticipated

In light of the approach taken in the Notice, it is anticipated that commentators will continue to request that the IRS provide additional guidance as the types of transactions to which the economic substance doctrine applies or does not apply. Commentators may argue that guidance is especially necessary given the complexity of the economic substance doctrine jurisprudence, the uncertainty regarding the application of section 7701(o), and the large strict liability penalty that applies to transactions that fail the requirements of the statute.

The LMSB Directive

The LMSB Directive requires that in order 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 of Field Operations before the penalty is proposed." By elevating the decision-making process to this level, it would appear that IRS leadership is sending a strong signal to its examination teams that the strict liability penalty should only be asserted in the most egregious situations.

Disclosure to Avoid Imposition of the Increased 40 Percent Strict Liability Penalty

As noted above, taxpayers may have an incentive to disclose transactions on their returns to avoid the increased 40 percent strict liability penalty in a manner that ensures that the disclosure satisfies the "adequate disclosure" requirements of the statute. In this regard, the Notice provides that for non-reportable transactions these requirements are satisfied if the taxpayer adequately discloses the relevant facts affecting the tax treatment of a transaction on a timely filed original return or a qualified amended return (i.e., Form 8275 or Form 8275-R). A disclosure that is considered adequate for reduction of the substantial understatement penalty will be deemed adequate for this purpose. The disclosure does not need to specify why the transaction is being disclosed -- that is, the taxpayer is not required to reveal the purpose of its disclosure. The Notice provides that with respect to reportable (i.e., listed) transactions, taxpayers must satisfy the requirements for non-reportable transactions as well as the disclosure requirements of the section 6011 regulations. The Notice specifically requests comments with respect to the disclosure requirements, particularly with respect to their interaction with Revenue Procedure 94-69, the proposed schedule of uncertain tax positions (Schedule UTP) and the LMSB compliance assurance program (CAP). Comments are due by December 3, 2010.

Unanswered Questions

Although the Notice addresses a few issues, the Notice does not address a number of significant issues that have been raised by commentators. For example, section 7701(o) does not define the term "transaction," other than providing that the term includes a "series of transactions." The JCT Explanation provides that courts may continue to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the economic substance doctrine. As a result of the uncertainty regarding the definition of a "transaction," commentators have questioned how the IRS or a court should apply the economic substance doctrine to the various elements of a transaction that is structured with tax efficiencies in mind. We hope future guidance will address this very important question.

In addition, with respect to the determination of pre-tax profit, the statute provides that the IRS "shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases." The Notice confirms that the IRS will in fact issue such regulations, without providing any further detail about the substance of future regulations. As commentators have noted, the statute provides the IRS with the discretion to issue regulations contrary to the Compaq and IES decisions, which were decided in favor of the taxpayer in part based on the conclusion that foreign taxes should not be treated as expenses in applying the economic substance doctrine. Unfortunately, the IRS has not provided any insight as to whether in fact it will exercise such discretion in its guidance.


The Notice represents the IRS’s initial guidance under the economic substance doctrine and will undoubtedly be followed by more detailed guidance in the form of proposed regulations. Nevertheless, the positions taken in the Notice with respect to the scope of transactions subject to the statute will require the exercise of professional judgment, as the IRS did not feel obliged to provide any certainty or comfort to taxpayers with respect to even the most basic business transactions like those described in the JCT Explanation. We doubt that as the regulatory process moves forward, there will ever be future guidance to address these important concerns, although the LMSB Directive should provide some level of comfort to taxpayers. Nevertheless, it appears that the courts will ultimately have to provide guidance to taxpayers with respect to the scope of transactions subject to the economic substance doctrine.

For more information, please contact:

Layla Asali,, 202-626-5866

Rocco Femia,, 202-626-5823

Marc Gerson,, 202-626-1475

Larry Gibbs,, 202-626-6005

Phil Mann

David Blair

George Clarke

Don Rocen

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