Notice 2014-58 adds some clarity to when the IRS will assert the strict-liability economic substance penalties and how they will determine the “transaction” that is disregarded under the Section 7701(o) economic substance doctrine.  The new guidance amplifies Notice 2010-62 and also formalizes some of the unofficial guidance in the 2011 IRS LB&I field directive.

IRS reserves the ability to aggregate or disaggregate transaction steps when defining “transaction”, depending on the facts

The question of what is the “transaction” is critical to the economic substance analysis, particularly when testing the overall motivations for a broader business transaction with certain tax-motivated steps.  The Notice clarifies that the term “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan.  However, the IRS will apply a facts and circumstances approach and may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals — a disaggregation approach.

IRS provides some clarity on when other tax doctrines are subject to strict liability economic substance penalties under “similar rule of law” rule

The economic substance doctrine “strict liability” penalties under section 6662(b)(6) apply to underpayments attributable to any disallowance of a claimed tax benefit under the section 7701(o) economic substance doctrine “or if the transaction fails to meet the requirements under any “similar rule of law”.  The Notice clarified that “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o), even if a different term or terms are used to describe the rule or doctrine.  The IRS referred to the sham transaction doctrine as one such example.  On the helpful side, the IRS stated that it will not apply the section 6662(b)(6) penalty unless it also raises section 7701(o) to support the underlying adjustments.  Further, the IRS stated that if tax benefits are denied under Code sections and regulations other than section 7701(o), they are not similar rules of law for purposes of the section 6662(b)(6) penalty.