On July 15, 2011, the IRS Large Business & International Division (“LB&I”) issued a directive entitled “Guidance for Examiners and Managers on the Codified Economic Doctrine and Related Penalties” (the “July 2011 Directive” or the “Directive”). Although the July 2011 Directive is not binding on the IRS, it likely will discourage the inappropriate application of the economic substance and prove to be a useful tool to taxpayers facing a potential application of the doctrine.

Key features of the July 2011 Directive include the following:

• The Directive provides a sort of “safe harbor” with a list of four categories of transactions for which it would be inappropriate to raise the economic substance doctrine. 
   
• Until further guidance is provided, the strict liability penalties associated with the codified economic substance doctrine will not be applied due to the application of any other similar rule of law or judicial doctrine, such as the step transaction doctrine.
   
• The Directive outlines a formal process that IRS examiners must follow before applying the doctrine to a transaction. The process should serve as a disincentive to the broad or indiscriminate application of the doctrine and will provide an opportunity for taxpayer input early in the process.
   
• If a transaction involves a series of interconnected steps with a common objective, the July 2011 Directive provides that an examiner who seeks to apply the doctrine to one or more individual steps must first seek guidance from his or her manager and consult with local counsel.

Extent of Statutory Guidance

Section 7701(o) provides 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.

If an underpayment is attributable to a transaction that fails this two-prong test (or any similar rule of law), the underpayment is subject to a 20 percent strict liability penalty. The penalty is increased to 40 percent if the taxpayer does not disclose the transaction on its return.

The statute provides almost no guidance on the threshold issue of what kinds of transactions the Service will test under this statute. Section 7701(o) states that it will apply "[i]n the case of any transaction in which the economic substance doctrine is relevant[,]" and 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." Thus, one must look to pre-enactment case law, which tends to apply the doctrine only to transactions that create significant tax advantages that Congress did not intend.

Fleshes Out 2010 Directive

A directive issued to IRS examiners last September required a review by and approval from the Director of Field Operations (DFO) before an examiner could apply the economic substance doctrine and assert a strict liability penalty. The stated purpose of the July 2011 Directive is to “instruct examiners and their managers how to determine when it is appropriate to seek the approval of the DFO in order to raise the economic substance doctrine.” Importantly, an examiner that is considering an application of the doctrine to any particular transaction is directed to notify the taxpayer as soon as possible, but no later than when the examiner begins an analysis under the steps described below. That notice will provide the taxpayer with an opportunity to provide further factual information or statements of position to the examiner or other members of the audit team.

Four-Step Process

The July 2011 Directive sets out a four-step process for seeking DFO approval:

The first step is to evaluate whether the circumstances in the case are those under which application of the doctrine is not likely to be appropriate. The directive lists 18 factors that tend to show that application of the doctrine is likely unwarranted. Most of these factors are stated in the negative. For example, the Directive discourages application of the doctrine when “the transaction contains no unnecessary steps” or when “the transaction does not accelerate a loss or duplicate a deduction.” Also listed as a factor is whether the transaction that generates targeted tax incentives is consistent with Congressional intent in providing the incentives. The Directive also lists the substantive prongs of the economic substance doctrine (whether the transaction creates a meaningful economic change on a present value basis, whether the transaction has credible business purpose apart from federal tax benefits, and whether the transaction has meaningful potential for profit apart from tax benefits) as factors.

If some, but not all, of the factors are present, an examiner may still proceed to steps two through four if the examiner still believes that application of the doctrine is warranted.

Importantly, the July 2011 Directive sets forth four “safe-harbor” categories of transactions. These categories are similar to transactions identified in the legislative history as inappropriate targets of the economic substance doctrine:

• The choice between capitalizing a business enterprise with debt or equity;
   
• A U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment;
   
• The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and
   
• The choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied.

The July 2011 Directive doesn’t prohibit the examiner from proceeding if a transaction falls within one of the enumerated categories, but one wonders how receptive the DFO might be in such a circumstance.

The second step is to determine whether factors indicate that assertion of the doctrine may be appropriate. The directive lists 17 factors that indicate that the doctrine should be applied. With one exception—transaction generates targeted tax incentives within Congressional intent—this list is the mirror image of the list of negative factors from step 1.

The third step is to develop the case for approval. The July 2011 Directive requires the examining agent to address a series of questions—whether the transaction is an election, whether it is subject to a detailed statutory or regulatory scheme, etc.—that appear designed to prevent the inappropriate application of the economic substance doctrine.

The fourth step is to request approval from the DFO. If the examiner wants to apply the economic substance doctrine after considering the questions in step three, then the examiner, in consultation with the examiner’s manager, must make a written submission to the DFO seeking approval to assert the doctrine. The July 2011 Directive instructs the DFO to consult with Counsel and to provide the taxpayer with an opportunity to express its position, either in person or in writing, before a final decision is rendered. This is welcome news. Taxpayers should receive notice early in the examination process and a second notice at the end of the process. At a minimum, a taxpayer will receive notice and will be afforded an opportunity to make its case before the DFO determines that the application of the economic substance doctrine is warranted. It is unclear whether taxpayers will be permitted access to the agent’s written submission showing the analysis of the various factors outlined in the July 2011 Directive.

Conclusion

Although the July 2011 Directive is not a binding guidance, it should provide taxpayers with increased comfort as to the circumstances in which the IRS will and will not be seeking to apply the economic substance doctrine. It establishes substantial institutional hurdles that must be overcome before the doctrine can be applied. Furthermore, the Directive will undoubtedly carry weight at audit and in the Appeals context, especially in circumstances where application of the enumerated analytical factors weighs against the assertion of the doctrine.

For more information, please contact:

Rocco Femia, rfemia@milchev.com, 202-626-5823

David Zimmerman, dzimmerman@milchev.com, 202-626-5876

David Blair

George Clarke

Joseph Helm

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