The economic substance doctrine was codified in the Health Care and Education Reconciliation Act of 2010 (the Act), Pub. L. No. 111-152, applicable to transactions entered into on or after March 31, 2010. The codification is silent regarding the transactions to which the economic substance doctrine applies, but once the doctrine has been determined to apply, new section 7701(o) of the Code provides the criteria under which a transaction is to be evaluated for economic substance. Section 7701(o) treats a transaction as having economic substance only if (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The test is conjunctive, not disjunctive.
Any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (under section 7701(o) or any similar rule of law) is subject to a 20% accuracy-related penalty under new section 6662(b)(6). If the relevant facts affecting the tax treatment of the transaction are not adequately disclosed in the taxpayer’s return (or a statement attached to the return), the underpayment attributable to such transaction is subject to a 40% strict liability penalty under new section 6662(i). The penalty is imposed on a strict liability basis—the reasonable cause exception does not apply. On September 14, 2010, the IRS issued LMSB Directive, LMSB 4-0910-024, requiring that any assertion of the strict liability penalty be approved by the Director of Field Operations.
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