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reasonable-cause defense and no pen-
alty relief even if a taxpayer receives an Sec. 7701(o)(1)(B) requires that the taxpayer
opinion on the transaction. According-
ly, if a transaction is determined to lack have a substantial purpose, apart from any
economic substance, the tax benefits of federal income tax benefit, for entering into
the transaction are disallowed and the
strict-liability penalty applies. the transaction.
The Joint Committee on Taxa-
tion (JCT) report for Sec. 7701(o)
(JCX-18-10) provides certain safe and their managers regarding the is provided on how to request
harbors addressing when the doctrine codified economic substance doctrine DFO approval.
is not meant to apply. These include and related penalties was set forth in
“certain basic business transac- IRM Section 4.46.4 and IRM Exhibit The four steps were elaborated
tions,” including: 4.46.4-4. upon in IRM Exhibit 4.46.4-4. The
1. The choice between capitalizing IRM Section 4.46.4.12.9 sum- guidance there for Step 1 provided 18
a business enterprise with debt or marized the four steps examiners were facts and circumstances that tend to
equity; required to take before a penalty could show the application of the economic
2. A U.S. person’s choice between be asserted under Secs. 6662(b)(6) and substance doctrine to a transaction
using a foreign corporation or a 6662(i), stating: is likely not appropriate, such as that
domestic corporation to make a the transaction generates targeted
foreign investment; Step one — DOCTRINE LIKELY tax incentives consistent with con-
3. The choice to enter into a transac- NOT APPROPRIATE: The gressional intent in providing the
tion or series of transactions that examiners must evaluate a number incentives. Additionally, the guidance
constitute a corporate organization of factors that tend to show that provided that it is “likely not appro-
or reorganization under Subchapter application of the economic sub- priate to raise the economic substance
C; and stance doctrine to a transaction is doctrine” for transactions related
4. The choice to use a related-party likely not appropriate. If the exam- to the four “basic business transac-
entity in a transaction, provided that iner continues to believe that the tion” safe harbors listed above in the
the arm’s-length standard of Sec. doctrine applies, go to step two. JCT report.
482 and other applicable concepts Step two — DOCTRINE MAY The inquiries required in Step 3 of
are satisfied. BE APPROPRIATE: Requires IRM Section 4.46.4.12.9 were par-
The JCT report also provides that the examiner to evaluate further ticularly important and demonstrated
“it is not intended” that certain tax whether additional circumstances a preference for other approaches/
credits, such as those under Secs. 42, in the case are those that tend doctrines when possible and appro-
45, 45D, 47, and 48, be disallowed in to show that application of the priate. IRM Exhibit 4.46.4-4 listed
a transaction involving “the type of doctrine is appropriate. the seven inquiries to be made under
activity that the credit was intended to Step three — DEVELOPMENT this step:
encourage.” OF CASE FOR APPROVAL:
If the examiner continues to 1. Is the transaction a statutory or
Previous IRS approach believe the application of the regulatory election? If so, then
To understand how the memorandum doctrine is warranted after the application of the doctrine
makes it easier for the IRS to assert conducting steps 1 and 2, a series should not be pursued without
that a transaction lacks economic of seven inquiries must be made specific approval of the exam-
substance, it is necessary to summarize before seeking approval to apply iner’s manager in consultation
the detailed four-step process that the doctrine. with local counsel.
was previously required for relying on Step four — DFO [director of 2. Is the transaction subject to a
the doctrine. field operations] APPROVAL: detailed statutory or regulatory
Prior to the memorandum, the IRS If the examiner and his or her scheme? If so, and the transac-
had addressed the economic substance manager and territory manager tion complies with this scheme,
doctrine in a variety of notices and di- determine that the application of then the application of the
rectives. Robust guidance for examiners the doctrine is merited, guidance doctrine should not be pursued

www.thetaxadviser.com January 2023 35