Updates and guidance on key IRS practice developments.

• Author: Clark, Regina

Practice & Procedures

Memo removes IRS procedural requirements for economic substance arguments

On April 22, 2022, the IRS issued a memorandum to all Large Business & International Division (LB&I) and Small Business/Self-Employed Division (SB/SE) examination employees to communicate updated guidance for examiners and managers on the economic substance doctrine and related penalties (LB&I-04-0422-0014).The memorandum makes it easier for the IRS to assert that a transaction lacks economic substance or a business purpose by removing the previously required four-step process for relying on the economic substance doctrine, including the requirement for executive approval.

The memorandum's guidance supersedes the instructions in Internal Revenue Manual (IRM) Section 4.46.4.12.9, Economic Substance Doctrine; IRM Exhibit 4.46.4-4, Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties; and IRM Section 20.1.5.13.2, Penalty Administration, and will be added to IRM Section 4.10.13, Examination of Returns, Certain Technical Issues.

After first reviewing the background of the economic substance doctrine, the authors describe the previous IRS approach to the doctrine and then explain the changes set forth in the memorandum, providing some practical tips.

Background on the economic substance doctrine

Though historically a judicial concept, the economic substance doctrine was codified by Congress in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, by adding Sec. 7701(o), which defines the doctrine as follows:

The term "economic substance doctrine" means the common law doctrine under which tax benefits... with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. [Sec. 7701(0)(5)(A)] Sec. 7701(o)(1)(B) requires that the taxpayer have a substantial purpose, apart from any federal income tax benefit, for entering into the transaction.

Sec. 6662(b)(6) was also added to implement Sec. 7701(o) by imposing a 20% penalty on any underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance. Sec. 6676 extends the penalty to refund claims, and Sec. 6662(i) increases the penalty to 40% for nondisclosed transactions. This penalty is strict-liability, with no reasonable-cause defense and no penalty relief even if a taxpayer receives an opinion on the transaction. Accordingly, if a transaction is determined to lack economic substance, the tax benefits of the transaction are disallowed and the strict-liability penalty applies.

The Joint Committee on Taxation (JCT) report for Sec. 7701(o) (JCX-18-10) provides certain safe harbors addressing when the doctrine is not meant to apply. These include "certain basic business transactions," including:

1. The choice between capitalizing a business enterprise with debt or equity;

2. A U.S. person's choice between using a foreign corporation or a domestic corporation to make a foreign investment;

3. The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under Subchapter C; and

4. The choice to use a related-party entity in a transaction, provided that the arm's-length standard of Sec. 482 and other applicable concepts are satisfied.

   The JCT report also provides that "it is not intended" that certain tax credits, such as those under Secs. 42, 45, 45D, 47, and 48, be disallowed in a transaction involving "the type of activity that the credit was intended to encourage."

   Previous IRS approach

   To understand how the memorandum makes it easier for the IRS to assert that a transaction lacks economic substance, it is necessary to summarize the detailed four-step process that was previously required for relying on the doctrine.

   Prior to the memorandum, the IRS had addressed the economic substance doctrine in a variety of notices and directives. Robust guidance for examiners and their managers regarding the codified economic substance doctrine and related penalties was set forth in IRM Section 4.46.4 and IRM Exhibit 4.46.4-4.

   IRM Section 4.46.4.12.9 summarized the four steps examiners were required to take before a penalty could be asserted under Secs. 6662(b)(6) and 6662(i), stating:

   Step...