Advertising Material
August 5, 2011 HRO CONTACTS
Authored by Tim Glasgow
IRS ISSUES DIRECTIVE FOR FIELD EXAMINERS AND Charles Ramunno
Partner, Tax
MANAGERS ON THE CODIFIED ECONOMIC Denver
charles.ramunno@hro.com
SUBSTANCE DOCTRINE AND RELATED PENALTY 303.866.0232
Paul Smith
Executive Summary Partner, Tax
Denver
paul.smith@hro.com
The 2010 enactment of tax legislation codifying the common law economic 303.866.0215
substance doctrine created substantial concerns relating to the application of Tom Yearout
the doctrine, including (i) the potential for an overly broad application of the Partner, Tax
doctrine to routine transactions, (ii) the potential for a strict liability penalty of Denver
tom.yearout@hro.com
up to 40% on transactions to which the doctrine applies, and (iii) the difficult 303.866.0297
decision of whether to expressly disclose a transaction in order to reduce the
Steve Gaines
potential 40% penalty to 20%. New IRS field examiner guidance released by Partner, Tax
the IRS on July 15, 2011 has somewhat reduced taxpayer concerns regarding Colorado Springs
the potential for overly broad application of the doctrine to routine steve.gaines@hro.com
719.381.8443
transactions, and has provided a helpful new framework for analyzing the
possible applicability of the doctrine. Nevertheless, by its very nature, the Tim Glasgow
Senior Associate, Tax
application of the economic substance doctrine remains subjective and Denver
uncertain. As a result, taxpayers should consider the potential for its tim.glasgow@hro.com
application and the desirability of specific disclosure in connection with any 303.866.0334
transaction that has a significant component that arguably has no business Travis Logghe
purpose and/or is designed to leave a taxpayer in the same economic position, Associate, Tax
Denver
but with a substantially improved tax result. travis.logghe@hro.com
303.866.0209
Background
On July 15, 2011, the Large Business & International Division of the IRS issued
LB&I-4-0711-015 entitled “Guidance for Examiners and Managers on the
Codified Economic Doctrine and Related Penalties” (the “Directive”). The
Directive is intended to instruct IRS examiners and managers on how to identify
cases for potential application of the doctrine and whether to seek approval by
the Director of Field Operations (the “DFO”) to raise the economic substance
doctrine and impose the related strict liability penalty.
The codified economic substance doctrine, added in March 2010 as Section
7701(o) of the Internal Revenue Code, provides that in the case of any
transaction to which the economic substance doctrine is relevant, the
transaction is treated as having economic substance only if (i) it changes in a
This article is a periodic publication of Holme Roberts & Owen LLP and should not be construed as legal advice or
legal opinion on any specific facts or circumstances, nor is it intended to address specific disclosure or compliance
issues that may arise in particular circumstances or provide an exhaustive discussion of the topics discussed herein.
The contents are intended for general informational and educational purposes only, and you are urged to consult
counsel concerning your particular situation and any specific legal questions you may have. For further information
regarding the topics described herein, please contact the attorneys listed.
1700 Lincoln Street, Suite 4100 I Denver, Colorado 80203
tel 303-861-7000 I fax 303-866-0200 I www.hro.com
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meaningful way the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose
(aside from the federal income tax effects) for entering into the transaction. In addition, Congress
amended Section 6662 of the Code to impose a penalty of 20% (40% for undisclosed transactions)
(the “Economic Substance Penalty”) of any underpayment attributable to the disallowance of
claimed tax benefits by reason of the application of the economic substance doctrine. The new
penalty applies without regard to the reasonable cause exception. For a brief summary of the
economic substance legislation see Codification of the Common Law "Economic Substance
Doctrine": Taxpayers Subject to New Standards to Obtain Tax Benefits and Avoid Penalties. On
September 14, 2010, the IRS issued guidance which provides that any proposal to impose the
Economic Substance Penalty at the examination level must be reviewed and approved by the
appropriate DFO.
The Directive
The Directive expands and clarifies the September 2010 guidance by providing instructions to
examiners on how to determine when it is appropriate to seek the approval of the DFO for the
imposition of the Economic Substance Penalty. The Directive establishes a four-step process that
examiners and managers must follow before submitting a proposal to impose the Economic
Substance Penalty. In addition, the Directive instructs examiners to notify the taxpayer as soon as
possible when the examiner is considering application of the doctrine under this four-step process,
thereby giving the taxpayer the opportunity to provide additional information relevant to
consideration of the applicability of the doctrine.
The Four-Step Process
First, an examiner should evaluate whether the facts and circumstances in the case are those under
which application of the economic substance doctrine to a transaction is likely not appropriate. The
Directive lists 18 facts and circumstances that “tend to show” that application of the doctrine is likely
not appropriate, including, among others:
• The transaction is not promoted by the taxpayer’s tax department or an outside advisor;
• The transaction is not “highly structured”;
• The transaction contains no “unnecessary steps”;
• The transaction does not “artificially” limit the taxpayer’s potential for gain or loss;
• The transaction is not “prepackaged”; and
• The transaction generates “targeted tax incentives in form and substance consistent with
Congressional intent.”
In addition, the Directive specifically enumerates four safe-harbor transactions that are inappropriate
for the application of the economic substance doctrine, including (i) debt/equity capitalization
choices, (ii) the choice between using foreign or domestic corporations for foreign investments, (iii)
certain corporate reorganization structures, and (iv) certain arm’s-length related party transactions.
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Second, an examiner should evaluate whether the facts and circumstances in the case are those
under which application of the doctrine to the transaction may be appropriate. The Directive sets
forth 17 facts and circumstances (most of which are the mirror image of the positive factors
considered in the first step) where the IRS believes that the economic substance doctrine may be
appropriate including, among others:
• The transaction is prepackaged, or promoted, developed, or administered by the tax
department or outside advisors;
• The transaction is highly structured or contains unnecessary steps;
• The transaction is not at arm’s length with unrelated parties;
• The transaction involves a tax-indifferent counterparty that recognizes substantial income;
• The transaction has no significant risk of loss;
• The taxpayer’s potential gain or loss on the transaction is artificially limited;
• The transaction has no credible business purpose and has no meaningful potential for profit
apart from tax benefits; and
• The transaction is outside of the taxpayer’s ordinary business activities.
Third, if an examiner determines that application of the doctrine may be appropriate, the Directive
provides a series of inquiries the examiner must address in developing the case for approval to apply
the doctrine, including:
• Whether the transaction involves a statutory or regulatory election;
• Whether the transaction is subject to a detailed statutory or regulatory scheme;
• Whether precedent relating to the application of the economic substance doctrine’s
application to the type of transaction exists;
• Whether the transaction involves tax credits;
• Whether another judicial doctrine more appropriately addresses the alleged noncompliance
(if so, the Directive indicates that the economic substance doctrine should not be applied);
• Whether recharacterizing the transaction more appropriately addresses the alleged
noncompliance; and
• Whether, considering all arguments available to challenge the claimed tax result, the
application of the economic substance doctrine is the strongest.
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In connection with answering the foregoing inquiries, the examiner is directed to seek advice from
the examiner’s manager and local IRS counsel.
Fourth, if an examiner and his or her manager determine that application of the economic substance
doctrine has merit, the examiner and the manager, should describe in writing how the analysis was
completed and submit the written analysis to the DFO. The DFO will then review the written material
and consult with counsel. If the DFO believes it is appropriate to approve the request, the DFO
should provide the taxpayer an opportunity to explain its position. The DFO conveys the final
decision to the examiner in writing.
Conclusion
While the Directive is not authoritative guidance on which taxpayers may rely, it shows that the IRS
may exercise some restraint before asserting the Economic Substance Penalty in an audit. The
Directive establishes a procedural framework under which examiners must operate that will,
hopefully, avoid the arbitrary application of the economic substance doctrine. In addition, the
Directive’s detailed list of facts and circumstances provides some basis for taxpayers to evaluate
potential transactions, and the potential exposure to the Economic Substance Penalty.