The Internal Revenue Service has issued some internal guidance on the dreaded economic substance doctrine that suggests examiners will have to see some pretty ugly evidence before they are likely to raise a red flag on any given transaction.

The economic substance doctrine is a concept that arose in case law under varying interpretations, then was codified by Congress as part of its 2010 healthcare reform measures. It generally establishes that taxpayers can't get tax benefits for transactions that are pursued for no substantive reason beyond looking for a tax break, and it establishes stiff penalties for companies that push the limits in trying to claim them.

The IRS Large Business & International Division recently issued a directive to its examiners and managers about how to apply the economic substance doctrine in the field and when to get higher IRS authorities involved in instances where field staff members believe the doctrine should be invoked. “The directive is very pro-taxpayer,” says Jack Cummings, counsel with law firm Alston & Bird in Durham, N.C. “It can reasonably be read to take a lot of pressure off of compliance officers who have been probably fairly concerned about this.”

When Congress codified the economic substance doctrine, it did so in a way that led to some confusion, says Cummings. “Congress said we're not going to tell you what the economic substance doctrine is, but when the court says it applies, here's the test,” he says. “It left a lot of us scratching our heads as to what to do, particularly because the statute imposed a very high penalty if you lost a tax case under the doctrine.”

While the latest guidance is meant to give internal direction on how it will be applied, it serves as guidance for corporate tax and compliance staff as well, says Cummings. It maps out a four-step process for an examiner to follow in deciding whether to blow the whistle on a given transaction. Examiners are told to evaluate the circumstances from both a negative and affirmative viewpoint—that is whether application of the doctrine is likely not appropriate, then whether it may be appropriate. If the examiner needs to look further, the guidance outlines a series of questions to follow and gives instructions on how to engage higher authorities' approval.

Cummings says the guidance is specific enough that tax and compliance officers should be able to build their own internal checklists for assessing transactions to evaluate their risk of raising an examiner's concern. It's the best guidance corporate taxpayers have received so far, he says. “Up to now the government has not fleshed out the safe harbors,” he says. “You didn't have much to go on. Now with this directive, we know what the economic substance doctrine means to the IRS.”