Ivins, Phillips & Barker Codified Economic Substanc e: Navigating the Landscape with Chartered (Some) Recent Help from the IRS Jay M. Singer David D. Sherwood TEI New England Chapter – Needham, MA February 6, 2015
Agenda Background Judicial doctrines before codification IRC §§ 7701(o) and 6662(b)(6) Developments LB&I Directives IRS Notices Post-codification case law Tax planning considerations Ivins, Phillips & Barker 1 Chartered
Pre-codification Judicial Doctrines “Over the last seventy years, the economic substance doctrine has required disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality.” Coltec v. U.S. (Fed. Cir. 2006). Courts have sometimes used other names to signify the economic substance doctrine ( e.g. , sham transaction doctrine, business purpose doctrine). Other judicial doctrines include substance-over-form, step- transaction and sham in fact. Ivins, Phillips & Barker 2 Chartered
Pre-codification Economic Substance Doctrine In all its incarnations, the economic substance doctrine (ESD) is a two-prong test: Economic substance (objective): transaction changes taxpayer’s economic position in a meaningful way apart from federal tax effects. Business purpose (subjective): taxpayer has substantial purpose for engaging in transaction apart from federal tax effects. Before codification, the Federal circuit courts disagreed about how the two prongs interacted: Conjunctive test (1 st , 7 th , 11 th and Federal Circuits): need to fail both prongs. Disjunctive test (2 nd , 4 th , 8 th and D.C. Circuits): only need to fail one prong. Flexible Inquiry test (3 rd , 5 th , 6 th , 9 th and 10 th Circuits): rejected rigid analysis. Ivins, Phillips & Barker 3 Chartered
Section 7701(o) Effective for transactions entered into after March 30, 2010: The disjunctive version of the ESD now applies to all transactions (personal transactions of individuals excepted). If the taxpayer relies on profit potential to pass either prong: The present value of reasonably expected after-tax profits must be substantial relative to the present value of expected tax benefits. Fees and transaction expenses count. IRS is to issue regulations regarding treatment of foreign taxes. State and local taxes treated like Federal income taxes if related. Financial accounting benefits disregarded if relate to Federal income tax saving. “Relevance” of ESD is determined in same manner as if § 7701(o) had never been enacted. The term “transaction” includes a series of transactions. Ivins, Phillips & Barker 4 Chartered
Section 6662(b)(6) The accuracy-related penalties under § 6662 now apply to any disallowance of tax benefits due to failing ESD or the requirements of any “similar rule of law.” The penalty under § 6662(b)(6) is strict liability – no reasonable cause and good faith defense. The penalty under § 6662(b)(6) increases from 20% to 40% if the transaction is not “adequately disclosed.” Section 6676(c) imposes similar strict liability for the erroneous refund claim penalty (though it is always a 20% penalty). Ivins, Phillips & Barker 5 Chartered
Joint Committee Report The Technical Explanation of the Joint Committee on Taxation (the JCT Report) is the closest we have to legislative history, but it is not legislative history. JCT Report on meaning of “transaction” (citing Coltec ): “The provision does not alter the court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the doctrine.” JCT Report on meaning of “similar rule of law” : “It is intended that the penalty would apply to a transaction the tax benefits of which are disallowed as a result of the application of the similar factors and analysis that is required under the provision for an economic substance analysis, even if a different term is used to describe the doctrine.” Ivins, Phillips & Barker 6 Chartered
Joint Committee Report JCT Report on meaning of “relevance” : “The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.” The choice between capitalizing a business enterprise with debt or equity. A U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment. The choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C. The choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of § 482 and other applicable concepts are satisfied. Ivins, Phillips & Barker 7 Chartered
Notice 2010-62 The disjunctive version of the ESD now applies to all transactions. IRS will continue to rely on relevant case law in applying each prong. IRS will continue to follow pre-codification authorities with respect to whether the ESD is relevant. No intention to issue published guidance on “relevance”. Until regulations are issued, appropriate treatment of foreign taxes in evaluating profit potential is left to the courts. Adequate disclosure for purposes of keeping the ESD penalty at 20% means: Form 8886 for reportable transactions. For all other transactions, whatever counts as adequate disclosure under § 6662(d)(2)(B) (Forms 8275 and 8275-R, Schedule UTP, Rev. Proc. 94-69 and Rev. Proc. 2014-15). Ivins, Phillips & Barker 8 Chartered
LB&I Directives September 14, 2010 – Any proposal by IRS Exam to impose the ESD must be reviewed and approved by the appropriate Director of Field Operations (DFO). July 15, 2011 – Sets forth the “inquiries” that IRS Exam must develop and analyze in order to seek approval of the imposition of the ESD. This is a four-step process (discussed in detail below). The Directive also turns off the “similar rule of law” concept for penalties until further guidance is issued. Ivins, Phillips & Barker 9 Chartered
July 15, 201 1 LB&I Directive Step 1 – Facts and circumstances that tend to show that the ESD is likely not appropriate: Not promoted/developed/administered by Tax Dep’t or outside advisor. Not highly structured. Contains no unnecessary steps. Consistent with Congressional intent in providing tax incentives. Arms’ length terms with unrelated parties. Meaningful economic change on a pre-tax present value basis. Potential for gain or loss is not artificially limited. No acceleration of a loss or duplication of a deduction. Deductions matched by an equivalent economic loss or expense. No offsetting positions that largely reduce or eliminate economic risk. No tax-indifferent counterparty that recognizes substantial income. Ivins, Phillips & Barker 10 Chartered
July 15, 201 1 LB&I Directive Step 1(continued): No separation of income recognition from a related deduction either between different taxpayers or with the same taxpayer in different years. Credible business purpose apart from federal tax benefit. Meaningful potential for profit apart from tax benefit. Significant risk of loss. Tax benefit is not artificially generated. Not pre-packaged. Not outside the taxpayer’s ordinary business operation. The transaction relates to one of the four “basic business transactions.” Step 2 – Facts and circumstances that tend to show that the ESD may be appropriate: The reverse of all the facts and circumstances in Step 1, except consistency with Congressional intent and “basic business transactions” not included. Ivins, Phillips & Barker 1 1 Chartered
July 15, 201 1 LB&I Directive Step 3 – Development of case for approval. Seven inquiries that can lead to needing examiner’s manager’s approval to continue: Is transaction a statutory or regulatory election? Is transaction subject to a detailed statutory of regulatory regime? Does precedent exist that rejects application of ESD? Does transaction involve tax credits designed to encourage behavior? Does another judicial doctrine more appropriately address noncompliance? Does recharacterizing the transaction more appropriately address noncompliance? Is the ESD among the strongest arguments available? Ivins, Phillips & Barker 12 Chartered
July 15, 201 1 LB&I Directive Step 4 – DFO Approval. Approval should be sought in writing. DFO should consult IRS counsel. The taxpayer should be given opportunity to explain their position, in writing or in person (at DFO’s discretion). DFO’s final decision should be conveyed to Exam in writing. Ivins, Phillips & Barker 13 Chartered
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