The Internal Revenue Service issued further guidance last fall on the codified economic substance doctrine and related penalties. Notice 2014-58 amplifies the original Notice 2010-62. The new Notice provides guidance regarding: (i) the definition of a “transaction” for economic substance purposes; and (ii) the meaning of “a similar rule of law” in the accuracy-related penalty provisions of Internal Revenue Code section 6662(b)(6). Notice 2014-58 also addresses the reasonable cause exceptions under Code sections 6664(c) and (d), and the reasonable basis exception under section 6676. These exceptions are inapplicable to transactions described in Code section 6662(b)(6).
The economic substance doctrine is a partly-evolved judicial doctrine that was purportedly codified by the Health Care and Education Reconciliation Act of 2010. Code section 7701(o)(5)(A) attempts to define the “economic substance doctrine” as the common-law doctrine that disallows income tax benefits, if the transaction that produces those benefits lacks economic substance or a business purpose. This is a rather simplistic statement, and ignores the low threshold for business purpose, for transactions that involve a lot of money and paperwork.
Under section 7701(o)(1), a transaction (or series of transactions) has economic substance 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 the transaction. The legislative history explained: “The provision does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine. For example, the provision reiterates the present-law ability of the courts to bifurcate a transaction in which independent activities with non-tax objectives are combined with an unrelated item having only tax-avoidance objectives in order to disallow those tax-motivated benefits.” H.R. Rep. No. 111-443(I), at 296-297, P.L. 111-152, Health Care and Education Reconciliation Act of 2010.
The term “transaction” has been defined by Treasury in the analogous context of reportable transactions, as “all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement and also includes any series of steps carried out as part of a plan.”
Code section 6662(b)(6) imposes a penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance (within the meaning of section 7701(o)) or fails to meet the requirements of any “similar rule of law”. A penalty was intended by Congress for a transaction that is disregarded as a result of the application of the same factors and analysis required under section 7701(o) for an economic substance analysis, even if a different term is used to describe the doctrine. H.R. Rep. 111-443(I), at 304.
Code sections 6664(c)(2) and (d)(2) provide that the reasonable cause and good faith exception to a section 6662 or 6662A penalty does not apply to an underpayment attributable to transactions described in section 6662(b)(6).
For purposes of the penalty for an erroneous claim for refund or credit of an excessive amount, Code section 6676(c) provides that any excessive amount (within the meaning of section 6676(b)) that is attributable to a section 6662(b)(6) transaction is not treated as having a reasonable basis.
Notice 2014-58 provides that, for purposes of determining whether the codified economic substance doctrine applies, a “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any of the steps carried out as part of a plan. Facts and circumstances determine whether a plan’s steps are aggregated or disaggregated when defining a transaction.
Generally, when a plan that generated a tax benefit involves a series of interconnected steps with a common objective, the “transaction”includes all of the steps taken together: an aggregation approach. When a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, an aggregation approach may not be appropriate. In that case, the “transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals: a disaggregation approach. For example, if transfers of multiple assets and liabilities occur and the transfer of a specific asset or assumption of a specific liability was tax-motivated and unnecessary to accomplish a non-tax objective, then the economic substance doctrine may be applied solely to the transfer or assumption of that specific asset or liability. Separable activities may include the use of an intermediary. These situations are neither exhaustive or comprehensive.
For purposes of section 6662(b)(6), “a similar rule of law” means a rule or doctrine that disallows the tax benefits under subtitle A of the Code related to a transaction because: (1) the transaction does not change a taxpayer’s economic position in a meaningful way (apart from Federal income tax effects); or (2) the taxpayer did not have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. In other words, a “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis, even if different terms (e.g., “sham transaction”) are used. H.R. Rep. 111-443, at 304. The Service will not apply a penalty under section 6662(b)(6) (or otherwise argue that a transaction is described in section 6662(b)(6)), unless it also raises section 7701(o) to support the underlying adjustments. If the IRS does not raise section 7701(o) and relies upon other judicial doctrines (e.g., substance over form or step transaction), the Service will not apply a section 6662(b)(6) penalty (or otherwise argue that a transaction is described in section 6662(b)(6)), because the Service will not treat the transaction as failing to meet the requirements of a similar rule of law. Code sections and Treasury regulations, other than section 7701(o) and the regulations under that section, that disallow tax benefits are not similar rules of law for purposes of section 6662(b)(6).