IRS gives limited guidance on economic substance.

The IRS has provided indications of its plans regarding the codified economic substance doctrine and the enhanced penalty for transactions lacking economic substance in formal guidance to taxpayers and its examiners, as well as in informal statements made by IRS representatives. However, in this guidance, the IRS has steadfastly refused to identify any specific types of transactions it will consider to have economic substance.

Background

The courts originally created the economic substance doctrine to disallow a transaction's tax benefits if the transaction lacks economic substance. It allowed courts to enforce Congress's statutory intent in situations in which a literal reading of the Code would allow a taxpayer to circumvent this intent.

While the courts generally agree on the definition of the economic substance doctrine, they have applied a number of different tests to determine whether a transaction has economic substance. Some courts use a single-element test and some use a two-element test. Under the single-element test, a transaction has economic substance if, viewed objectively, there is a nontax business purpose for the transaction. The taxpayer's subjective intentions regarding the transaction are not taken into account (see Coltec Industries, 454 F.3d 1340 (Fed. Cir. 2006)). Under the two-element test, a transaction has economic substance if (1) the transaction, viewed objectively, has economic substance and (2) the taxpayer has a subjective business purpose for the transaction.

Adding to the confusion, courts that use the two-element test for economic substance have not been consistent in applying it, in some cases requiring that both elements be satisfied, in others requiring that either one of the two elements be satisfied, and in others taking both elements into consideration as part of the determination of whether a transaction has economic effects other than those derived from its tax benefits (see, e.g., Pasternak, 990 F.2d 893 (6th Cir. 1993); Rice's Toyota World, 752 F.2d 90 (4th Cir. 1985); IES Industries, 253 F.3d 350 (8th Cir. 2001); ACM Partnership, 157 F.3d 231 (3d Cir. 1998); James, 899 F.2d 905 (10th Cir. 1990); Sacks, 69 F.3d 982 (9th Cir. 1995)).

As it had long threatened to do, Congress enacted legislation to codify the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. The act added new Sec. 7701(o), which adopts a two-prong test, providing that in the case...