On October 9, 2014, the IRS issued Notice 2014-58, which provides much needed guidance on the economic substance penalty under IRC §7701(o). The Notice speaks to 1) the definition of “transaction”, and 2) the application of the term “similar rule of law” for accuracy related penalties under IRC §6662(b)(6). It represents the IRS’ latest effort to combat tax-avoidance mechanisms.

The economic substance doctrine was codified as §7701(o) by the Health Care and Education Reconciliation Act of 2010. Under the doctrine, a transaction has economic substance if it changes in a meaningful way the taxpayer’s economic position and the taxpayer has a substantial purpose for entering into such a transaction. While §7701 codifies the economic substance doctrine, it fails to define what a transaction is, aside from it “relating to a series of transactions.” Notice 2014-58 attempts to clarify by stating that “’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.” It reaches its definition of “transaction” by analogizing to the definition of a reportable transaction under §1.6011-4(b)(1) and references nontax legislative history.

The Notice provides that when a plan with a series of interconnected steps generates a tax benefit, every step of the transaction will be considered together. However, a disaggregation approach may be taken in a given case—meaning when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, the “transaction” will include only the tax motivated steps.

In illustrating the potential applications of the disaggregation rule, the notice relies on two rather broad examples suggesting a potentially overreaching ability of the IRS to cherry-pick transactions in order to make an economic substance argument.

The second part of the Notice defines “similar rule of law” in §6662(b)(6). Under that section, a taxpayer is subject to penalty on an underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance and thus is subject to §7701(o) or any “similar rule of law.”

Because §6662 does not define “similar rule of law,” Notice 2014-58 explains that the phrase refers to any doctrine that “applies the same factors and analysis that is required under §7701(o) for an economic substance analysis, even if a different term or terms (for example, “sham transaction doctrine”) are used….” Therefore, the IRS will not raise the application of a “similar rule of law” if it does not raise §7701(o). As a result, the step transaction and substance over form doctrines will not be subject to §6662(b)(6) penalties because they are not “similar rules of law”.

While Notice 2014-58 provides some guidance on the application §7701, it does not offer complete clarity on which transactions the IRS will attack or when penalties may apply. Moreover, it appears to allow the IRS to cherry-pick transactions. As a result, careful tax planning when engaging in a series of tax-beneficial transactions remains crucial.