Codification of the Economic Substance Doctrine: Agency Response and Certain other Unforeseen Consequences

Abstract

Section 7701(o) of the Internal Revenue Code incorporates the controversial judicial doctrine of economic substance into statutory language. In other words, it “codifies” the doctrine. (The economic substance doctrine generally provides that a tax benefit that goes beyond Congressional intent can be disallowed by the courts, even if the taxpayer meets all of the literal Code and regulatory requirements for claiming the benefit).

This codification appears to have accidentally dissuaded the relevant agency (the Internal Revenue Service, or IRS) from raising economic substance issues — an effect that is contrary to Congress’ intent in enacting the doctrine into legislation. The IRS response to codification raises bigger picture issues, such as an agency’s ability to disregard (or decline to enforce) a statute and the parameters of an agency’s ability to issue public guidance using informal means (rather than formal regulations).

In addition, this codification raises structural issues, including the interaction between the three branches of government in this context and the impact of Congressional approval on arguments about the validity of this judicial doctrine. Lastly, such codification places new emphasis on distinguishing between the now-codified economic substance doctrine and other anti-abuse doctrines.

Keywords: tax, federal income tax, 7701(o), economic substance

JEL Classification: K34