The codified economic substance doctrine and related penalties.

• Author: Yu, David

The IRS issued a directive on July 15, 2011, from its Large Business and International (LB&I) Division (LB&I-4-0711-015) to help examiners and their managers determine the appropriateness of seeking the approval of the director of field operations (DEO) when raising the economic substance doctrine. This was a follow-up to a previous LB&I directive (LMSB-20-0910-024) issued on September 14, 2010, that summarized the codification of the economic substance doctrine and related penalties. The July 15 directive further details a multistep process that the examiner must develop before the ultimate application of the doctrine in the examination. It also provides guidance on related penalties that might be imposed upon the application of the doctrine.

Background on the Economic Substance Doctrine

The Health Care and Education Reconciliation Act of 2010, RL. 111-152 [the Health Care Act), codified a conjunctive economic substance test in new Code Sec. 7701{o). Sec. 7701 (o) disallows certain tax benefits if the transaction does not have economic substance or a business purpose. The new statute is effective for transactions entered into after March 30, 2010, which was the date of the act's enactment. Under this new C^ode section, a transaction is considered to have economic substance as long as it meets a two-part conjunctive test. A transaction will have economic substance if, apart from federal income tax effects:

* The transaction changes in a meaningful way the taxpayer's economic position; and

* The taxpayer has a substantial purpose for entering into such transaction.

Background on Related Penalties

The Health Care Act also added Sec. 6662(b)(6), which imposes a 20% strict liability penalty for any underpayment attributable to claimed tax benefits that are disallowed because of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty rate is increased to 40% when the underpayment is attributable to one or more "nondisclosed noneconomic substance transactions," which are any transactions for which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return (Sec, 6662(i)).

Amendments to Sec. 6664 clarify that the reasonable cause exception does not apply to the Sec. 6662(b)(6) penalty (Sec. 6664(d)(2)). In addition, a corresponding amendment to Sec. 6676 specifies that a strict liability penalty limited to 20% also...