Practitioners Want More Specifics on Codified Economic Substance Doctrine

Dear Sirs:

We are writing to request that the Department of the Treasury ("Treasury") and Internal Revenue Service ("IRS") issue substantive guidance on selected issues regarding the codified economic substance doctrine and related no-fault penalty.¹ Although the economic substance doctrine codification and the new no-fault penalty raise many substantive and procedural issues that could be addressed in guidance, we focus on the substantive issues that we believe present the most urgent need for guidance. We recommend that Treasury and the IRS issue guidance on (1) when the economic substance doctrine is "relevant" to a transaction; (2) the definition of "transaction;" and (3) the meaning of "any similar rule of law" under the new penalty provisions.

I. Recommended Guidance

We urge Treasury and the IRS to reconsider Notice 2010-62, which states that Treasury and the IRS "do not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply." Although Treasury and the IRS need not write an "angel list" of specific transactions to which the economic substance doctrine is not relevant, we believe that some guidance on when the economic substance doctrine is relevant to a transaction is urgently needed.⁴

Notice 2010-62 states:

By using the relevance of the doctrine as the trigger for application of the statutory provisions, Congress clearly intended that not all transactions be subject to the new conjunctive test. Taxpayers and their advisers may analyze whether the test is relevant to a transaction by considering the JCT Technical Explanation to the economic substance doctrine legislation (discussed below), prior case law, and administrative practice. Nevertheless, the novelty of the "relevance" concept means that it is difficult to gain comfort on even routine transactions. Even if a taxpayer and its advisers diligently analyze the issues, real risk of a penalty, up to 40%, will remain.

The JCT Technical Explanation, which describes two general types of tax results not intended to be altered by codification of the economic substance doctrine, should be the basis for the two rebuttable presumptions. The first presumption should be based on the statement in the JCT Technical Explanation that "[i]f the realization of the tax benefits is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed."⁶ The JCT Technical Explanation further explains, "it is not intended that a tax credit . . . be disallowed in a transaction pursuant to which, in form and substance, a taxpayer makes the type of investment or undertakes the type of activity that the credit was intended to encourage."⁷ Consistent with this approach, guidance should provide that a transaction will be considered to be within the first presumption if the taxpayer shows that the transaction satisfies the technical rules of a provision and that the tax results are consistent with a Congressional purpose or plan. Transactions within this presumption could include credits, such as those mentioned in the JCT Technical Explanation, as well as transactional "fictions" mandated by the Code and other tax benefits or results specifically mentioned as intended by Congress in a provision's legislative history.⁸

The second presumption should be based on the statement in the JCT Technical Explanation that codification "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."⁹ The Technical Explanation provides several examples of these "basic business transactions":

If a transaction does not clearly fall in one of the above presumptions, it should be tested under a "facts and circumstances" test.¹² This test should list both factors suggesting the economic substance doctrine is relevant and factors suggesting that the economic substance doctrine is not relevant. Consistent with section 7701(o)(5)(C), which states that "the determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted," the factors would look to case law and administrative practice.

Similar to the regulations under sections 355(a)(1)(B)¹³ and 355(e),¹⁴ the facts and circumstances test could provide:

The statute does not address whether and to what extent a court should focus on a narrow piece of a larger transaction.²² The JCT Technical Explanation, however, states:

We are concerned that revenue agents may interpret "any similar rule of law" as including any statutory, regulatory, or judicial anti-abuse or recharacterization rules. The JCT Technical Explanation states, however, that the phrase should be narrowly construed:

II. Conclusion

The codified economic substance doctrine and associated no-fault penalty create substantial uncertainty for taxpayers and tax practitioners. We believe that guidance can be developed, as suggested above, that provides useful guidance for taxpayers without limiting the IRS's ability to attack abusive transactions. We urge the Treasury and IRS to issue guidance on the important issues described above.

² All sections references are to the Internal Revenue Code of 1986, as amended, and all references to "Treas. Reg. §" are to the regulations thereunder, unless otherwise stated or clear from context.

³See Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as amended, in combination with the "Patient Protection and Affordable Care Act" (JCX-18-10), March 21, 2010 (the "JCT Technical Explanation"), at p. 152 (stating that codification "does not change present law standards in determining when to apply an economic substance analysis").

⁴ It may be argued that establishing firm rules on when the economic substance doctrine is or is not relevant to a transaction (such as an "angel list") could encourage taxpayers to use such rules to plan around the doctrine and enter into transactions the IRS finds abusive. We do not believe our proposal would encourage abusive transactions. Rather, as discussed below, our proposal would establish rebuttable presumptions and a series of facts and circumstances that would provide taxpayers and practitioners with a framework for considering whether economic substance is relevant, but would not automatically "bless" transactions.

⁵ Treas. Reg. § 1.355-2(d)(1), (2), (3), (5).

⁶ JCT Technical Explanation, supra note 3, at p. 152, n. 344.

⁷Id.

⁸See, e.g., H.R. Conf. Rep. No. 101-964 (1990) (with respect to section 355(d), providing examples of transactions that do not fall within the purpose of the statute).

⁹ JCT Technical Explanation, supra note 3, at p. 152.

¹⁰Id.

¹¹Id. at p. 152 & n. 345.

¹² Our proposed list of "facts and circumstances" is similar, but not identical, to the factors suggested in the American Bar Association Section of Taxation and American Institute of Certified Public Accountants' January 18, 2011 letter to Treasury and the IRS.

¹³See Treas. Reg. § 1.355-2(d).

¹⁴See Treas. Reg. § 1.355-7(b)(3), (4).

¹⁵See Treas. Reg. § 1.355-7(b).

¹⁶See, e.g., section 269; Treas. Reg. § 1.701-2.

¹⁷See, e.g., Cottage Savings v. Commissioner, 499 U.S. 554 (1991).

¹⁸See id.; Sun Properties v. United States, 220 F.2d 171 (5th Cir. 1955).

¹⁹ As examples, the consolidated return regulations or the passive loss rules.

²⁰ For example, an election under section 338.

²¹See, e.g., ACM Partnership v. Comm'r, 157 F.3d 231 (3d Cir. 1998) ("In applying these [economic substance] principles, we must view the transactions 'as a whole, and each step, from the commencement . . . to the consummation . . . is relevant.'") (citation omitted).

²²See Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert denied 127 S. Ct. 1261 (2007) ("We must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale. That transaction is [the subsidiary's] assumption of [the liabilities]. . . . It is this exchange that provided [the taxpayer] with the high basis in the [subsidiary] stock, this exchange whose tax consequence is in dispute, and therefore it is this exchange on which we must focus.").

²³ JCT Technical Explanation, supra note 3, at p. 153.

²⁴ Section 6662(b)(6).

²⁵ JCT Technical Explanation, supra note 3, at p. 155 n.359.