Codified economic substance update: IRS issues more guidance.

• Author: Trivedi, Shamik

The IRS on Oct. 9 issued a notice providing additional guidance on the codified economic substance doctrine under Sec. 7701(o) and related penalty amendments.

Notice 2014-58 amplifies Notice 2010-62 and provides guidance on the definition of "transaction" in applying the economic substance doctrine under Sec. 7701(o) and on the meaning of "similar rule of law" under the Sec. 6662(b)(6) accuracy-related penalty. It is effective for transactions entered into after March 30, 2010.

Congress codified the economic substance doctrine as part of the Health Care and Education Reconciliation Act of 2010, RL. 111-152, by adding Sec. 7701(o), which states that a transaction has economic substance if it meets a two-part test: (1) The transaction must change in a meaningful way, apart from federal income tax effects, a taxpayer's economic position; and (2) the taxpayer must have a substantial purpose, apart from federal income tax effects, for entering into the transaction. The term "economic substance" is defined under Sec. 7701(o)(5)(A) as the common law doctrine that disallows tax benefits under subtitle A of the Code, if the transaction that produces those benefits lacks economic substance or a business purpose.

Definition of "Transaction"

Notice 2014-58 applies an aggregation definition to "transaction," in that a transaction "generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan." Thus, when a plan that generates a tax benefit involves a series of interconnected steps with a common objective, the transaction is considered to include all of the steps in the aggregate--resulting in each step's being considered when analyzing whether the transaction as a whole lacks economic substance.

However, when a plan includes a series of steps, including a tax-motivated step that is not necessary to achieve a nontax objective, the notice indicates that the IRS may apply a dis-aggregation approach to determine whether any of the individual tax-motivated steps is considered a transaction subject to the economic substance doctrine. So the IRS is free to aggregate or disaggregate steps of an overall transaction in assessing the application of the economic substance doctrine on a case-by-case basis.

This definition is...