Codification of the Economic Substance Doctrine is Not a Change in Substantive Law

Oct 12, 2010   

The economic substance doctrine was codified on March 30, 2010 in IRC § 7701(o) providing that transactions shall be treated as having economic substance only if the transaction changes the taxpayers economic position in a meaningful way and the taxpayer has a substantial purpose for entering into the transaction.

IRC § 7701(o)(5)(C) further states that the doctrine only applies to a transaction entered into in connection with a trade or business or activity engaged in for income. IRC § 7701(o)(5)(D) provides that the term “transaction” includes a series of transactions.

As it relates to transactions with a potential for profit, IRC § 7701(o)(2)(A) provides that the economic substance doctrine is applied only if the present value of the reasonably expected pre-tax profits is substantial in relation to the present value of the claimed net tax benefit.

On October 5, 2010, IRS Associate Chief Counsel, William D. Alexander, speaking at a panel discussion sponsored by the Boston Bar Association, said that the newly codified economic substance doctrine does not constitute a change in substantive law. Mr. Alexander instead said that the codification affects issues of proof and stressed that when planning a transaction one cannot plan the transaction around issues of proof. Mr. Alexander explained that when planning a transaction, the transaction should be based on the assumption that all facts will become known and entered into the record and thereafter appropriately appreciated by the finder of fact and determiner of law. Thus, practitioners who have been structuring transactions based on the reality of the transactions will not be affected by the codification of the economic substance doctrine.

Taxpayers have requested published guidance on the doctrine since its codification on March 30, 2010. In response, the IRS issued a notice, Notice 2010-62, describing how the IRS plans to administer the doctrine moving forward. The notice also explains guidance on penalties and foreign taxes. The IRS, however, does not intend to issue guidance on specific transactions that would or would not pass muster under the doctrine or so-called Angel List transactions.

During his discussion, Mr. Alexander noted that the doctrine is rooted in common law and because common law is evolving, the IRS may “take a run on an existing authority which it might think . . . was wrongly decided.”

Our professionals at Fuerst Ittleman PL are knowledgeable in the newly codified economic substance doctrine. If you believe you have been affected by the new law please contact our professionals at