Commissioner , 91 T. In contrast, the Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of the arrangements under I. Waters v. The view, as adopted by these circuits, is that, in determining who has the ultimate liability for an obligation, the economic substance and the commercial realities of the transaction control.
See Waters v. Commissioner , 94 T. Commissioner , 89 T. Thornock v. To avoid the application of I. The transaction is carefully structured so that any gain in one option position is largely offset by a loss in another contract. See Knestch v. United States , U. Accordingly, this doctrine is applicable to the typical Notice transaction where the purported tax benefits are unintended by Congress and accomplished by a prearranged deal that serves no economic purpose apart from tax savings.
In determining whether a transaction is to be respected for tax purposes, both the objective economic substance of the transaction and the subjective business motivation are considered. ACM Partnership v. Some courts apply a conjunctive analysis that requires a taxpayer to establish the presence of both economic substance i. See Pasternak v. Other courts apply a less stringent test that either a subjective business purpose or actual economic substance is sufficient.
See also Casebeer v. Commissioner , 69 F. In addition, several courts have applied the economic substance doctrine where a taxpayer was exposed to limited risk and the transaction had a theoretical potential for profit but the profit potential was nominal and insignificant when compared to the tax benefit derived. Gregory v. Helvering , U. See also Compaq Computer Corp v. The doctrine of economic substance should be raised in cases where the facts show that the transaction at issue was primarily designed to generate the tax losses, with little if any possibility for profit, and that such was the expectation of all the parties to the transaction.
The wide variety of facts required to support its application should be developed at examination. The administrative record should include documents obtained from the taxpayer, the promoter and other third parties; interviews with the same; and expert analysis of financial data and industry practices.
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Summonses should be promptly issued whenever necessary to obtain the requisite transactional documents. In addition to evidence that shows a lack of pre-tax profit potential, facts should be developed demonstrating that the taxpayer and the promoter primarily planned the transaction for tax purposes. Such evidence should include the following: 1 documents or other evidence that the foreign currency option contracts were sold as tax shelters with limited consideration of the underlying economics of the transaction; and 2 evidence that a prudent investor would not have invested in the strategy but for the tax savings.
A primary source of such evidence is correspondence between the promoter and the taxpayer, including, but not limited to, offering memos, letters identifying tax goals, e -mails and in-house communications at the offices of the promoter and any other third party involved in the strategy. Written correspondence is the best evidence, but evidence of oral communications regarding tax goals is also useful.
Demonstrations of similarities of the nature and extent of tax losses acquired by other clients of the promoter in this shelter can be very important as well. In the typical case, the transaction fails both prongs of the economic substance analysis. The following facts underscore a lack of a legitimate potential or realistic possibility for a pre-tax profit i. Although not a traditional straddle, the option contracts create substantially offsetting positions whereby any gain in one contract is offset in another contract.
Second, the profit, if any, would be derived from the contractual provision that required a payment equal to twice the premium amount to the holder if the strike price was at or above a stated amount on the exercise date.
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Third, the net premium paid to enter the option contracts is a mere 1. Fourth, any potential profit realized would be further reduced by significant up -front transaction costs. Fifth, the only true profit potential comes from the additional hedge fund investment that represents a distinct investment separate from the foreign currency scheme. These facts persuasively demonstrate the lack of any realistic potential for pre-tax profit from the foreign currency strategy. The transaction also fails the subjective economic substance prong. Typically, the taxpayer has significant taxable income either capital gain income or ordinary income unrelated to the transaction.
Through participation in this transaction, the taxpayer is able to choose the character and amount of the loss needed to offset the unrelated income. The close connection between the taxable income being sheltered and the claimed loss suggests that the taxpayer did not enter into this transaction for a business purpose. Here, the taxpayer does not have a substantial non-tax purpose for entering into the structured transaction other than the creation of an artificial tax loss. As discussed herein, various circuits apply different standards in determining whether a transaction lacks economic substance.
Prior to asserting economic substance, the examiner should consult with local Counsel to determine the appropriate standard in their jurisdiction. In general, I. The I. The legislative history of I. Accordingly, in enacting I. In response to Congressional concern about tax motivated transactions, the Service, under the authority of I. In this case, the transaction at issue may be recharacterized in accordance with its substance so that the taxpayer is required to take i nto account gain as well as the economically corresponding loss under Treas.
For purposes of I. The claimed loss is not the result of exposure to exchange rate fluctuations, but rather of differences in timing of recognition of economically offsetting gain and loss positions in an engineered transaction. Accordingly, under Treas. Alternatively, the loss may be excluded from I. Excluding the transaction from the provisions of I.
Barnes Group v. Supp D. The 20 percent accuracy-related penalty under I. Thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is 20 percent 40 percent for gross valuation misstatements , even if that portion of the underpayment is attributable to more than one type of misconduct. See D. After the general overview, some more practical suggestions are offered based on the information that has been reviewed to date — including the above -referenced shelter promotion materials and Shelter Memorandum.
Much of the focus in that later discussion is on substantial understatement. Negligence under I. See I. Negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances. See Marcello v. Commissioner , 85 T.
A return position that has a reasonable basis as defined in Treas.
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Therefore, if the facts indicate that a taxpayer took a return position contrary to any published notice or revenue ruling, the taxpayer may be subject to the accuracy-related penalty for an underpayment attributable to disregard of rules and regulations, if the return position was taken subsequent to the issuance of the notice or revenue ruling. The accuracy-related penalty for disregard of rules and regulations will not be imposed on any portion of underpayment due to a position contrary to rules and regulations if: 1 the position is disclosed on a properly completed Form or Form R the latter is used for a position contrary to regulations and 2 in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of a regulation.
This adequate disclosure exception applies only if the taxpayer has a reasonable basis for the position and keeps adequate records to substantiate items correctly. Moreover, a taxpayer who takes a position contrary to a revenue ruling or a notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits. Marcello v. With respect to examinations commencing after July 22, , however, the Service must first meet the burden of production with respect to negligence.
Specific rules apply to the calculation of the understatement when any portion of the understatement arises from an item attributable to a tax shelter. Because a significant purpose of the Notice transaction is tax avoidance, it is a tax shelter pursuant to I. Different rules, however, apply depending upon whether the taxpayer is a corporation or an individual or entity other than a corporation. In the case of any item of a taxpayer other than a corporation, which is attributable to a tax shelter, understatements are generally reduced by the portion of the understatement attributable to: 1 the tax treatment of items for which there was substantial autho rity for such treatment, and 2 the taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment.
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Here, there was no substantial authority for the tax treatment of this transaction. However, a taxpayer cannot claim to have reasonably relied in good faith on the opinion of a professional tax advisor if the requirements of Treas. If the item is attributable to a tax shelter and the taxpayer is a corporation, the understatement cannot be reduced. Therefore, if a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy related penalty applies to the underpayment arising from the understatement unless the reasonable cause and good faith exception applies.
Special rules apply to items of a corporation attributable to a tax shelter resulting in a substantial understatement. The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all relevant facts and circumstances. See Treas. All relevant facts, including the nature of the tax investment, the complexity of the tax issues, issues of independence of a tax advisor, the competence of a tax advisor, the sophistication of the taxpayer, and the quality of an opinion, must be developed to determine whether the taxpayer was reasonable and acted in good faith.
For example, reliance on erroneous information reported on an information return indicates reasonable cause and good faith, provided that the taxpayer did not know or have reason to know that the information was incorrect. Similarly, an isolated computational or transcription error is not inconsistent with reasonable cause and good faith. Circumstances that may suggest reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the facts, including the experience, knowledge, sophistication and education of the taxpayer.
See Kees v. If the taxpayer is misguided, unsophisticated in tax law, and acts in good faith, a penalty is not warranted. See Collins v. Spears v. Commissioner, T. Reliance upon a tax opinion provided by a professional tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty.
The reliance, however, must be objectively reasonable, as discussed more fully below.
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For example, the taxpayer must supply the professional with all the necessary information to assess the tax matter. The advice also must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances. The advice must not be based on unreasonable factual or legal assumptions including assumptions as to future events and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. In Long Term Capital Holdings v. Where a tax benefit depends on nontax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter.
See Novinger v. Further, if the tax advisor is not versed in these nontax matters, mere reliance on the tax advisor does not suffice. See Addington v. See Neonatology Associates, P. Commissioner , 39 F. Commissioner , 90 T. Similarly, the fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable. Edwards v. For example, a taxpayer may not rely on an independent tax adviser if the taxpayer knew or should have known that the tax adviser lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, or the information the advisor was provided was not accurate.
When it appears that imposing the accuracy-related penalty is warranted, the examiner needs to carefully evaluate the application of the penalty for each taxpayer that is audited. This review is made somewhat easier by the fact that taxpayers must satisfy more stringent standards to avoid application of the penalty where the substantial understatement is in connection with a tax shelter transaction.
From a practical standpoint, it will be critical for the examiner to focus upon whether the taxpayer based its return position on a more likely than not legal opinion of a professional tax advisor that considered all pertinent facts and lines of legal authority. Based on the review of the limited materials gathered to date in connection with this shelter transaction, it may be quite difficult for taxpayers to show that they satisfied that standard. If the taxpayer has not reasonably relied on such an opinion, then the accuracy-related penalty should be asserted.
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If the draft Shelter Memorandum is a good barometer of the quality of the opinions, if any, provided to taxpayers, the examiner may find that highly pertinent facts were overlooked or misstated. For instance, it is plainly troubling that the draft Shelter Memorandum reached its conclusions regarding section by assuming that the assigned foreign currency options were not substantially offsetting positions even though separate promotional documents clearly tout the positions as being almost completely offsetting.
Moreover, the legal memorandum virtually ignores all discussion of the economics and legal effects of the assignments. In addition, it will be critical to examine whether the legal opinion addressed all relevant lines of legal authority. As a guide, the examiner should determine if each of the legal issues raised in this CIP were meaningfully considered. The draft Shelter Memorandum was clearly deficient in that regard.
For instance, the legal memorandum failed to consider any authority that addresses the tax accounting for options and failed to consider whether the form of assignment caused gain or loss to be recognized under the open transaction doctrine. Though section was considered, the draft memorandum also failed to consider the anti-abuse rules of Treas.