Agenda Background Judicial doctrines before codification IRC - - PowerPoint PPT Presentation

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Codified Economic Substance:

Navigating the Landscape with (Some) Recent Help from the IRS

Jay M. Singer David D. Sherwood

TEI New England Chapter – Needham, MA February 6, 2015

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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

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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.

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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 (1st, 7th, 11th and Federal Circuits): need to fail both prongs.
• Disjunctive test (2nd, 4th, 8th and D.C. Circuits): only need to fail one prong.
• Flexible Inquiry test (3rd, 5th, 6th, 9th and 10th Circuits): rejected rigid analysis.

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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.

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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).

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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.”

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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.

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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).

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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.

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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.

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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.

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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?

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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.

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Notice 2014-58

• “Transaction”
• When a plan that generated a tax benefit involves a series of

interconnected steps with a common objective, “ transaction” includes all of the steps taken together – an aggregation approach.

• When a series of steps includes a tax-motivated step that is not

necessary to achieve a non-tax objective, the “ transaction” may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals – a disaggregation approach.

• E.g., transfer of specific asset or assumption of specific liability was

tax-motivated and unnecessary to accomplish a non-tax objective.

• E.g., use of an intermediary employed for tax benefits and whose

actions or involvement was unnecessary to accomplish an

• verarching non-tax objective.
• Facts and circumstances determine whether a plan's steps are

aggregated or disaggregated when defining a transaction.

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Notice 2014-58

• “Similar Rule of Law”
• Means a rule or doctrine that applies the same factors and

analysis that is required under § 7701(o) for an economic substance analysis, even if a different term or terms (e.g., “sham transaction doctrine”) are used to describe the rule or doctrine.

• IRS will not apply a § 6662(b)(6) penalty (or otherwise argue that

a transaction is described in § 6662(b)(6)) unless it also raises § 7701(o) to support the underlying adjustments.

• The substance-over-form and step-transaction doctrines and

Code sections and Treasury regulations (other than § 7701(o)) that disallow tax benefits are not “similar rules of law.”

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PLRs on § 7701(o) Not Available

• Rev. Proc. 2015-3 – Domestic “no rule” areas
• “Whether the economic substance doctrine is relevant to any

transaction or whether any transaction complies with the requirements of § 7701(o).”

• Rev. Proc. 2015-7 – International “no rule” areas
• “Whether a taxpayer has a business purpose for a transaction
• r arrangement.”
• Absence of “relevance” of economic substance doctrine on the

list should not be read as an invitation to ask for a ruling on it.

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Post-Codification Case Law

• There are not yet any decided cases involving application of

§§ 7701(o) or 6662(b)(6).

• Pre-codification cases very rarely explicitly tackle the

relevance question. Generally, the courts analyze the two prongs whenever the Government asserts the ESD.

• We expect the law on “relevance”, “transaction” and “similar

rule of law” to develop as courts start dealing with post- codification cases.

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Tax Planning Considerations

• Section 7701(o) was not intended as the death of tax planning.

For taxpayers in pre-codification “disjunctive test” jurisdictions, little beside the strict liability penalty has changed.

• The “relevance” question, which largely boils down to whether

the business purpose prong applies, can be determinative of whether tax planning is respected. Unfortunately, authorities on “relevance” are limited.

• The strict liability penalty has increased the risks of tax planning.

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Tax Planning Examples

• Selling an investment on December 31 instead of January 1.
• Selling an investment and repurchasing it 31 days later.
• “Busting” a type-B reorganization using boot (property
• ther than voting stock).
• Refreshing NOLs by engaging in a sale-leaseback.

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Worthless Stock Loss

20 Parent Insolvent Subsidiary Parent Insolvent Subsidiary

• Section 165(g)(3) generally permits a

corporation to claim an ordinary worthless stock loss if:

• 90% of the gross receipts of the

subsidiary are from active sources;

• the stock has become worthless

during the taxable year; and

• there has been an “identifiable event”

fixing the worthlessness.

• Rev. Rul. 2003-125 treats a check

the box election resulting in a deemed liquidation of an insolvent subsidiary as an “identifiable event.”

• Impact of § 7701(o)?

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Granite Trust Transactions

21 Sub 1 Sub 2 Parent Sub 3 NQPS 30% Sub 3 Stock Parent Sub 1 Sub 2 Sub 3 70% 30%

• Sub 1 sells 30% of the stock of Sub 3

to Sub 2 for non-qualified preferred stock of Sub 2.

• A check-the-box election is filed to treat

Sub 3 as a partnership.

• Result: deemed taxable liquidation of Sub 3

under §§ 331 and 336 followed by a deemed § 721 contribution.

Impact of § 7701(o)?

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Electivity by Form

22 Parent Target

A B

IP

25% Merger Sub LLC 75%

A

Target Parent Merger Sub

B

IP

25% 75%

• Tax-free to A and Target as a section

368(a)(1)(A) reorganization.

• Tax-free to B as a section 351

transaction.

• Tax-free to A and Target as a section

368(a)(1)(A)/(a)(2)(D) reorganization.

• Taxable to B.

Impact of § 7701(o)?

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23 Shareholder Group A PubCo Public OpCo

Up-C Structure

OpCo Units PubCo Stock

• OpCo units are exchangeable

for PubCo stock.

• Exchanges are taxable but

may give rise to basis increase in OpCo assets.

• Income tax receivable

agreement?

• Impact of § 7701(o)?

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Jay M. Singer

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JAY SINGER is a partner in the Washington, DC office of Ivins, Phillips & Barker. Jay advises clients on tax aspects of corporate transactions, particularly domestic and cross‐border mergers and acquisitions, tax‐free spin‐offs and internal

• restructurings. Jay previously worked as an attorney in the IRS National Office

and the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP and as an adviser in the national office of Deloitte Tax LLP. While at the IRS National Office, Jay drafted corporate tax regulations and other published guidance such as private letter rulings addressing complex public company transactions. Since leaving the IRS, he has advised major public companies and private equity firms on tax‐ efficient structuring of complex acquisitions and dispositions. His varied background in corporate tax provides his clients with a unique balance of technical expertise and practical advice. He is currently the vice‐chair of the DC Bar Corporate Tax Committee and a frequent public speaker on matters of corporate taxation. Jay speaks fluent French and Spanish.

Partner – Corporate Tax Washington, D.C.

jsinger@ipbtax.com

O: 202 662 3457 F: 202 393 7601

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David D. Sherwood

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DAVID SHERWOOD is a partner in the Washington, D.C. office of Ivins, Phillip & Barker, having joined the firm in 2000. He has extensive experience in advising clients on a broad range of domestic tax issues affecting corporations, joint ventures and their owners, including the tax treatment of spin‐offs and other restructurings, consolidated returns, the availability of deductions on the worthlessness or other disposition of stock, financial products and partnership special allocations. In addition, his training in economics and mathematics before becoming a lawyer, as well as business valuation training since becoming a lawyer, has provided him with the ability to incorporate an understanding of complicated business appraisals and financial models with the tax advice he

• provides. He is also involved with issues concerning the disclosure of tax shelters

and other reportable transactions.

Partner – Corporate Tax Washington, D.C.

dsherwood@ipbtax.com

O: 202 662 3478 F: 202 393 7601