IRS Issues Guidance on the Application of the Codified Economic Substance Test


In March of last year, the Health Care and Education Reconciliation Act of 2010 (the "2010 Act") reconciled a long standing conflict among the circuit courts regarding the scope of the economic substance doctrine and codified the test in section 7701(o) of the Internal Revenue Code of 1986, as amended (the "Code"). The statute generally provides that certain tax benefits are not allowable if a transaction does not have economic substance and a transaction shall be treated as having economic substance only if —

(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

(B) the taxpayer has a substantial purpose (apart from Federal

income tax effects) for entering into such transaction (the "Codified Economic Substance Doctrine").

The 2010 Act also imposed a penalty on any underpayment attributable to the disallowance of claimed tax benefits from transactions lacking economic substance or failing to meet the requirements of any similar rule of law (the "Economic Substance Penalty"). The strict liability penalty is imposed at a rate of 20 percent but is increased to 40 percent if the taxpayer fails to adequately disclose the relevant facts relating to the transaction. The Codified Economic Substance Doctrine is discussed, in further detail, in the Bracewell client alert dated April 1, 2010.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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