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Substance, form & ambiguity: the IRS economic substance doctrine
For years, the economic substance doctrine was argued by the IRS and enforced by the courts, although it appeared nowhere in the Internal Revenue Code. In 2010, however, the economic substance doctrine was finally codified by the Health Care and Education Reconciliation Act. Unfortunately, the new code sections by design neglected to provide when the economic substance doctrine would apply. Thus, although there is now a definition of the economic substance doctrine, there remains substantial uncertainty as to when a transaction will be subjected to it. In mid-December, Daniel Rosen, special trial attorney with the IRS's Large Business and International Division (LB&I), announced that it "has no intention to issue guidance on when the economic substance doctrine will apply." Additionally, he provided that the IRS would not be issuing an "angel list" of transactions deemed to meet economic substance requirements since the IRS does not want a bright-line test. He further noted that the IRS would like to see a body of case law develop around the economic substance doctrine.
All of this comes as no real surprise to those who have followed this and related issues over the past few years. The IRS has been aggressive in its application of economic substance concepts both to transactions that strike practitioners as obviously questionable and to those that historically were considered safe. The IRS has won a series of recent court decisions that support its view.
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Also published in Thomson Reuters' Taxnet Pro, 14 February 2014
In summary, the IRS considers the issue of economic substance as highly subjective. As a result, it is prime for dispute, and ultimately a high number of cases are likely to remain unresolved at the examination level. Since many economic substance issues involve material items where the taxpayer is unwilling to accept the proposed assessment, particularly in light of the 20 percent and 40 percent penalties, this may often lead either to settlement at appeals or possibly to a higher percentage of litigation, given the IRS's view that it would like to see the courts provide a body of case law on the subject.
When the IRS issued the examination directive in 2011, it appeared the IRS might be willing to issue more bright-line standards; however, these do not appear to be forthcoming. As a result, taxpayers would be well advised to continue to seek specific tax-structuring advice for their transactions, thereby increasing the likelihood that the arrangement will be viewed as having economic substance. Therefore, we also suggest contemporaneous documentation of the business purposes and the related financial analysis, in addition to documentation of how the deal was structured.