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By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
Continuing the unfortunate modern trend of issuing guidance only by Notice, even years after the enactment of the relevant Code provision, the IRS promulgated brief but important guidance on the §7701(o) codified economic substance doctrine (ESD) on October 9, 2014, in Notice 2014-58. The Notice provides guidance on two points: (1) the definition of "transaction"; and (2) the meaning of "similar rule of law."
Section 7701(o) provides that, in the case of any "transaction" with respect to which the ESD is relevant, the "transaction" will be treated as having economic substance only if the "transaction" meets a two-prong test. Under the Notice, the term "transaction" means just about whatever the IRS wants it to mean. Thus, the IRS can aggregate steps in a series of steps or can disaggregate steps in a series of steps to identify the tested "transaction." The entire series of steps must, in the aggregate, satisfy the ESD. However, when a series of steps includes a step (or subgroup of steps) not necessary to achieve the business purpose, that individual step (or subgroup of steps) will be the "transaction" that must satisfy the ESD on its own. Likewise, in a transfer of multiple assets and liabilities, a particular asset or liability transfer may constitute the "transaction" if that specific transfer was unnecessary to accomplish the overall business purpose.
This interpretation gives the widest possible reading to the decision in Coltec.1 It also appears to be more flexibly IRS-friendly than even the definition of "transaction" in the reportable transaction disclosure regime.2 Such interpretation is not surprising, however, since the House Budget Committee Report (the "Report")3 on a bill that, after some amendment, became the bill that enacted §7701(o), suggested, citing Coltec, that courts already had the ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the ESD.
What is mildly surprising is that the Notice specifically calls the Report "legislative history" relevant to the definition of "transaction." The §7701(o)(5)(D) definition of "transaction" as "includ[ing] a series of transactions" was not included in the bill that the Report was explaining. Therefore, while a tad misleading (given the clear implication in the Notice that the quote from the Report was explaining §7701(o)(5)(D)), it is nevertheless logical to use the quote from the Report given the relevance of aggregating/disaggregating to the concept of "transaction."
What will be useful to taxpayers from all this has little or nothing to do with the definition of "transaction." By calling the Report "legislative history" of §7701(o), the Notice eliminates whatever hesitation practitioners have had to use the Report and its so-called "angel list" as authority for concluding the ESD is not relevant to several types of transactions. The angel list section of the Report provides as follows:
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. Among these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person's choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) 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. [Footnotes omitted.]
Even though various IRS and Treasury personnel have been quoted in the tax press as insisting that there is no angel list and that there will be no guidance creating or describing one, the citation in the Notice of the Report as legislative history does all that is necessary, practically, in confirming an angel list's existence. Prior to the Notice's endorsement of the Report as legislative history, there was at least a scintilla of doubt that it could be so cited, given that it reported on a somewhat different bill than the one enacted.
"Similar Rule of Law"
Section 6662(b)(6) imposes a "no-fault" penalty on an underpayment of tax resulting from a transaction that lacks economic substance or fails to meet the requirements of any similar rule of law. Neither §7701(o) nor §6662 defines "similar rule of law." Again, however, the Report provides some elaboration and the Notice approvingly cites the Report as legislative history.
Consistent with the Report's explanation, the Notice defines "similar rule of law" as a rule or doctrine that disallows income tax benefits under the same principles as the ESD. Thus, such a rule must deny benefits because either: (1) there is no meaningful change in the taxpayer's economic position; or (2) the taxpayer had no substantial non-tax business purpose. The Notice cites as an example of such a similar rule of law the sham transaction doctrine. This is also consistent with the Report, though it might have been helpful for the IRS to distinguish between sham-in-fact versus legal sham.4
Importantly, the Notice states that the IRS will not apply the §6662(b)(6) no-fault penalty if it relies on a judicial doctrine such as the substance-over-form or step transaction doctrine, unless it also asserts that the §7701(o) ESD applies. This clearly implies, correctly in this commentator's view, that the substance-over-form and step transaction doctrines are not similar rules of law to the ESD. Further, the Notice states that Code sections and regulations other than §7701(o) and the regulations thereunder are not similar rules of law for purposes of §6662(b)(6).
This clarification of an inherently ambiguous phrase, and its appropriate apparent narrowing, is confirmation of what practitioners hoped was the case. Whether the required assertion of §7701(o) before the §6662(b)(6) penalty is asserted is simply an exercise of administrative discretion designed to keep the world operating smoothly or is actually an interpretation of the term "similar rule of law," this confirmation is most welcome.
This commentary also will appear in the December 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Keinan, 508 T.M., The Economic Substance Doctrine, and in Tax Practice Series, see ¶3830, Penalties.
1Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006).
2 Reg. §1.6011-4(b)(1).
3 H.R. Rep. No. 111-443, Pub. L. No. 111-152, Health Care and Education Reconciliation Act of 2010.
4 It is inconsistent, however, with the LB&I Directive dealing with this, that was issued in 2011 (LB&I-4-0711-015), though admittedly that Directive merely stated that sham transactions would not involve the §6662(b)(6) penalty "until further guidance is issued."
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